Basic Concepts of Stock

What is Stock and How does it Works?

Stocks represent ownership in a publicly-traded company. When you buy a

company's stock, you become part-owner of that company. For example, if a
company has 100,000 shares and you buy 1,000 of them, you own 1% of it.
Owning stocks allows you to earn more from the company's growth and gives you
shareholder voting rights.

Companies sell stocks to gain additional funds to grow their business, launch
new products, or pay off debt. The first time a company issues stocks to the public
is called the initial public offering (IPO). After the IPO, stockholders can resell their
shares on the stock market—where prices are driven by supply and demand.

The more people selling a stock, the lower the price will drop; the more people
buying a stock, the higher the price will rise. Generally, people buy or sell stocks based
on expectations of corporate earnings or profits. If traders think a company's earnings
are high or will rise further, they bid up the price of the stock.

One way that shareholders make a return on their investment is by selling shares at
a higher price than they were purchased. If a company doesn't do well, and its
shares decrease in value, its shareholders could lose part or even all of their
investment when they sell. The other way shareholders profit is through dividends,
which are quarterly payments distributed on a per-share basis out of a company's
earnings. It is a way to reward and incentivize stockholders—the actual owners of the
company—for investing. It's especially important for companies that are profitable
but may not be growing quickly.

Source: https://www.thebalance.com/what-are-stocks-3306181
 There are two types of stocks namely, the common stocks and the preferred
stocks. These types of stocks differ in two main areas. First is in terms of the voting rights.
Only common stockholders are given opportunity to participate in voting such as
electing the company's board of directors and on certain corporate policies. Second
is in terms of the dividend sharing.

Although shareholders of both types of stocks are entitled to dividend

payment, preferred stock is similar to fixed income investment in which the
company pays fixed dividends to the shareholders at regular intervals. This is not
always the case for common stockholders. Preferred shareholders are given priority over
common shareholders.
 Stock Valuation

The stocks are considered to have high value if the stockholder gets higher dividend at present and in the
future, otherwise the stock is considered to have a low value. The computation of the stock value is
necessary in order to know if the stock
market value is cheap or expensive at a given time.

There are different ways of valuing stocks. One of these is the dividend discount model. This model
attempts to find the true value of an investment. In this section, the
following notations and formulas will be used:

Notations and Definitions of Terms

Notation Description

P0 Stock’s Value or Stock Price

D0 Current Dividend

D1 Year 1 Dividend

r Required return’s rate

g Dividend’s growth rate

Pn Terminal future price

 Solving for the Value of Stocks

Stock valuation is an important tool that can help you make informed

decisions about trading. It is a technique that determines the value of a company's

stock by using standard formulas. It values the fair market value of a financial

instrument at a particular time.

The following formula shows how value of stocks are computed;

Given Formula

Current Dividend

Rate of Returns 𝐷0 (1 + 𝑔)
𝑃0 = 𝑟−𝑔
Dividend Growth Rate

Year 1 Dividend 𝐷1
Rate of Returns 𝑃 =
0
𝑟−𝑔
Dividends Growth Rate

Present Value of a series of

𝐷1 𝐷2 𝐷 𝑃𝑛
dividends Rate of Returns 𝑃0 = + (1+𝑟)2….+ 𝑛 3+ (1+𝑟) 𝑛
(1+𝑟) (1+𝑟)
Present Value of the Terminal Price
Illustrative Examples

Example 1.1

The current dividend paid to the common stock holders of ABC Corporation is
₱50 per share. Dividends are expected to grow at an annual rate of 6%. The market
requires a rate of 13% on ABC common stock. What is the stock's current price?

Solution: The problem provided as the given:

Current Dividend: D0 = ₱50

Dividend Growth Rate: g= 6% or 0.06
Rate of Returns: r = 13% or 0.13

Base on the given, we will use the formula;

𝑃0 = 𝐷0 (1 + 𝑔)
𝑟−𝑔

𝑃 = 50(1 + 0.06)
0
0.13 − 0.06

𝑃 = 50(1.06)
0.07
0

𝑃0 = 53
0.07

𝑃0 = ₱757.14

Therefore, the current price of the stock is ₱757.14

 Example 1.2

Mr. Chu was offered a stock has a dividend of ₱80 per year. If he sells it after
3 years the price of the stocks is expected to go up to ₱1,000. The market requires a
rate of return of 11%. What is the value of the stock?

Solution: The problem provided as the given:

Series of Dividends: D1 = D2 = D3 = ₱80

Terminal Future Price: Pn= ₱1000
Rate of Returns: r = 11% or 0.11

Base on the given, we will use the formula;

𝑫𝟏 𝑫𝟐 𝑫𝟑 𝑷𝒏
𝑷𝟎 = + 𝟐 + 𝟑 +
(𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓)𝒏

80 80 80 1000
𝑃0 = +
(1 + 0.11) + (1 + 0.11)2 (1 + 0.11)3 + (1 + 0.11)

80
𝑃0 = 80 + 80 2 + 1000
(1.11) (1.11) (1.11)3 + (1.11)3

80
𝑃0 = 80 + 80 + 1000
1.11 1.2321⬚ 1.367631⬚ + 1.367631

𝑃0 = 72.0720 + 64.9297 + 58.4953 + 731.191

𝑷𝟎 = ₱𝟗𝟐𝟔. 𝟔𝟓

Therefore, the value of the stock is ₱926.65.

 Example 1.3

Referring to question above, what if the same stock dividend grows by 4% per
year? What would be its new value?

Solution: The problem provided as the given:

Series of Dividends: D1 = ₱80

D2 = ₱83.20
D3 = ₱86.528
Terminal Future Price: Pn= ₱1000
Rate of Returns: r = 11% or 0.11

Base on the given, we will use the formula;

𝑫𝟏 𝑫𝟐 𝑫𝟑 𝑷𝒏
𝑷𝟎 = + 𝟐 + 𝟑 +
(𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓)𝒏

80 80
80 + 1000
(1 + + (1 + 0.11) 2
(1 + 0.11)3 + (1 + 0.11)
0.11)

80
𝑃 = 83.20 + 86.528 + 1000
+
0
(1.11) (1.11)2 (1.11)3 (1.11)3

86.528
𝑃0 = 80 + 83.20⬚ + 1000
1.11 1.2321 1.367631⬚ + 1.367631

𝑃0 = 72.0720 + 67.5270 + 63.2685 + 731.191

𝑷𝟎 = ₱𝟗𝟑𝟒.06

Therefore, the new value of the stock is ₱934.06

 Example 1.4

Luiz was offered by GHI Company with stock amounting to ₱50 per share.
Dividends are expected to grow at an annual rate of 8%. The market requires a rate
of 12% on GHI common stock. What is the stock's current price offered to Luiz?

Solution: The problem provided as the given:

Current Dividend: D0 = ₱75

Dividend Growth Rate: g= % or
0.08 Rate of Returns: r = 12% or 0.12

Base on the given, we will use the formula;

𝑃0
𝐷0 (1 + 𝑔)
= 𝑟−𝑔
𝑃0
75(1 + 0.08)
= 0.12 − 0.08
𝑃
75(1.08)
0 =
0.04

𝑃0 = 81
0.04
𝑃0 = ₱2,025

Therefore, the current price of the stock is ₱2,025.

 Example 1.5

Ms. Lim was offered a stock has a dividend of ₱125 per year and expected to
grow 5% per year. If she sells it after 4 years the price of the stocks is expected to go
up to ₱2,000. The market requires a rate of return of 15%. What is the value of the stock?

Solution: The problem provided as the given:

Series of Dividends: D1 = ₱125

D2 = ₱131.25
D3 = ₱137.8125
D4 = ₱144.703125
Terminal Future Price: Pn= ₱2,000
Rate of Returns: r = 15% or 0.15

Base on the given, we will use the formula;

𝑫𝟏 𝑫𝟐 𝑫𝟑 𝑫𝟒 𝑷𝒏
𝑷𝟎 = + 𝟐 + 𝟑 + 𝟒 +
(𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓) (𝟏 + 𝒓)𝒏

125
𝑃 = 131.25 + 137.8125 144.703125 2000
+ + +
0
(1 + 0.15) (1 + 0.15)2 (1 + 0.15) 3 (1 + 0.15)4 (1 + 0.15)4

125 131.25 137.8125 144.703125 2000

𝑃0 = + + + +
(1.15) (1.15)2 (1.15)3 (1.15)4 (1.15)4

137.8125
𝑃0 = 125 + 131.25 ⬚ + 144.703125 2000
(1.15) (1.3225) (1.520875)⬚ + (1.74900625)⬚ + (1.74900625)⬚

𝑃0 = 108.6957 + 99.2439 + 90.6140 + 82.7345 + 1143.5065

𝑷𝟎 = ₱𝟏, 𝟓𝟐𝟒. 𝟕𝟗

Therefore, the value of the stock is ₱1,524.79.

Let’s Ty This!

Problem
Solving

The dividend of the common stock of a certain company will be ₱60 on the first year,

₱85 on the second year, and ₱120 on the third year. You can sell the stock after you

received the dividend of ₱200 at the end of the three years. If you required a 9% return on the

investment, how much will your value of stock today?

Solving for the Required Rate of Returns

The following formula shows how required rate of returns are computed;

Given Formula

Current Dividend

Stock Value 𝐷0 (1 + 𝑔)
𝑟= 𝑃0 +𝑔
Dividend Growth Rate

Year 1 Dividend
𝐷1
Rate of Returns 𝑟 = +𝑔
𝑃0
Dividends Growth Rate
 Example 2.1

X and Y Corporation is giving their common stock holders a current dividend of

₱40 per share and expected to grow 3% annually. The current stock price is ₱825. What
is the market required rate of return on the common stock?

Solution: The problem provided as the given:

Current Dividend: D0 = ₱40

Dividend Growth Rate: g= 3% or 0.03
Stock Value: P0 = ₱825

Base on the given, we will use the formula;

𝑫𝟎 (𝟏 + 𝒈)
𝒓= 𝑷𝟎 +𝒈

40(1 + 0.03)
𝑟= 825 + 0.03

40(1.03)
𝑟= 825 + 0.03

41.2
𝑟= + 0.03
825

𝑟 = 0.4993939394 + 0.03

𝒓 = 𝟎. 𝟎𝟕𝟗𝟗 𝒐𝒓 𝟕. 𝟗𝟗%

Therefore, the required rate of return is approximately 7.99%

 Example 2.2

What is the market required rate of return of the common stock that has a
current dividend of ₱95 and expected to grow 6% annually with the common stock
price of ₱1500?

Solution: The problem provided as the given:

Current Dividend: D0 = ₱95

Dividend Growth Rate: g= 6% or 0.06
Stock Value: P0 = ₱1500

Base on the given, we will use the formula;

𝑫𝟎 (𝟏 + 𝒈)
𝒓= 𝑷𝟎 +𝒈

95(1 + 0.06)
𝑟= 1500 + 0.06

95(1.06)
𝑟= 1500 + 0.06

100.7
𝑟= + 0.06
1500

𝑟 = 0.06713333 + 0.06

𝒓 = 𝟎. 𝟏𝟐𝟕𝟏𝟑𝟑 𝒐𝒓 𝟏𝟐. 𝟕𝟏𝟑𝟑%

Therefore, the required rate of return is approximately 12.7133%

 Example 2.3

A stock that pays a constant dividend of ₱60 forever sells for ₱428.40. What is the
required rate of return?

Solution: The problem provided as the given:

Current Dividend: D0 = ₱60

Dividend Growth Rate: g= 0 (since constant and no change at all)
Stock Value: P0 = ₱428.40

Base on the given, we will use the formula;

𝑫𝟎 (𝟏 + 𝒈)
𝒓= 𝑷𝟎 +𝒈

60(1)
𝑟 = 428.40 + 0

60
𝑟= +0
428.40

𝑟 = 0.1400560 + 0

𝒓 = 𝟎. 𝟏𝟒𝟎𝟎 𝒐𝒓 𝟏𝟒%

Therefore, the required rate of return is approximately 14%

LESSON SUMMARY

Stock is a share of ownership in a business or company. Stocks represent ownership in a

publicly-traded company. When you buy a company's stock, you become part-owner
of that company.

The stockholders are the owner of the firm. A stockholder (also known as a
shareholder) is the owner of one or more shares of a corporation's capital stock.

Stock Valuation is important in order to compare the price of the stock with respect to
the market value.
 POST TEST

Solving. Answer each of the following problems by showing your complete

solution.

1. The dividend of the common stock of a certain company will be ₱105 on the
first year, and ₱110.25 on the second year. You can sell the stock after you
received the dividend of ₱500 at the end of the two years. If you required a 14%
return on the investment, how much will your value of stock today?

Solution:

2. Keyla was offered by a certain company with stock amounting to ₱500 per
share. Dividends are expected to grow at an annual rate of 10%. The market
requires a rate of 20% on the company’s common stock. What is the stock's
current price offered to Keyla?
Solution:

3. What is the market required rate of return of the common stock that has a current
dividend of ₱305 and expected to grow 16% annually with the common stock
price of ₱800?

Solution:
 REFERENCES

Aoanan, G., Plarizan, M., Regidor, B., & Simbulas, L. (2019). General Mathematics for

Senior High School (Revised ed.). C & E Publishing Inc.

https://www.thebalance.com/what-are-stocks-3306181

http://www.stat.ufl.edu/~rrandles/sta4183/4183lectures/chapter03/chapter03R.pdf

https://www.deped.gov.ph/wp-content/uploads/2019/01/SHS-Core_General-Math-

CG.pdf