Valuation of Securities: Stock Valuation

The price of each share of a firm’s common stock is the value of each ownership interest. Although common stockholders typically have voting rights, which indirectly give them a say in management, their most significant right is their claim on the residual cash flows of the firm. This claim is subordinate to those of vendors, employees, customers, lenders, the government (for taxes), and preferred stockholders. The value of the common stockholders’ claim is embodied in the future cash flows they are entitled to receive. The present value of those expected cash flows is the firm’s share value. To determine this present value, forecast cash flows are discounted at a rate that reflects their risk. Riskier cash flows are discounted at higher rates, resulting in lower present values than less risky expected cash flows, which are discounted at lower rates. The value of the firm’s common stock is therefore driven by its expected cash flows (returns) and risk (certainty of the expected cash flows). In pursuing the firm’s goal of maximizing the stock price, the financial manager must carefully consider the balance of return and risk associated with each proposal and must undertake only those actions that create value for owners. By focusing on value creation and by managing and monitoring the firm’s cash flows and risk, the financial manager should be able to achieve the firm’s goal of share price maximization.

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