Pricing a Stock

I have gone deliberately slow trying to explain what stocks are. Shown you some data, because it's fascinating, but also because it is probably new to most of you. Not necessarily all of you obviously, and it's also little bit complex. So you need to understand what it means, it's a vehicle of investment. It also is a vehicle of borrowing by firms, by entities. So individuals don't issue stock, so that's another reason why I just wanted to give you some sense. So let's now start thinking about the price of a stock, and it's just mind bogglingly cool. So make an assumption. Let us assume that a company has only stock, no debt. Is this possible? Of course.

As I said, you start off with stock, but once you take on debt, that gets paid first. For simplicity, let's assume that there's no debt. And you'll see why. It makes life a little bit simple. Is this possible? Yes, it is. In fact, a lot of companies don't have debt because debt has some positives, very strong positives. But it also has some downsides. And one of the downsides is, if you're growing very fast and you've got to pay your debt holders and you can't default, you don't have money to reinvest necessarily. So that's one of the issues. One of the main advantages is interest on debt is tax deductible, whereas dividend is not.

Remember interest is the way you get money on debt. How do you get money on stocks? Dividends, and of course you can sell the stock anytime. So yes, you can have zero debt and for simplicity be both. Can you have zero stock? No. I mean, as I said, no company should give you any money if you don't have any skin in the game because you'll be incentivized to take too much risk. What will be the value of the company, if indeed, it had only stocks? And this is so cool. So imagine you have a company where there are a million shares trading. That means your company stock is at least trading in the stock markets.

And the good news is stock markets are everywhere. Of course, sometimes they're manipulated, they're controlled by insiders and so on, but in a competitive market, it's great. Stocks trade all the time. It's fascinating. So what will be the value of the company? Very simple. You have 1 million shares trading, and you look up finance.yahoo.com and we'll do that in the end. And you see price per share is $5, you just take five times number of shares and you know the value of the company. That's why I think markets and finance are so powerful. As I said, earlier at some point and I repeat right now, financing itself is not value creating. Real ideas are.

But if financing weren't available so freely, money wouldn't go to the best ideas of the world, okay? And that's the purpose of today's class, so let's start thinking about the price of a stock. So how is a stock priced? Let me throw up some jargon first, some symbols, and then we'll come back and start pricing the stock. So let's call P naught, P subzero, today's price. P subzero. I'm not going to write right now but I'll soon start writing.

What is P1? P1 is the expected stock price next year. What is P2? Expected stock price two years from now, and so on. Okay, you can call them years, months, whatever. You typically will say a year, okay? Assume that the expected dividend at the end of the year is called D1. Okay, many times you'll see in textbooks it's called dividends, div, div cap 1. So why am I calling expected stock price, expected dividends? Why in bold especially? And the notion is very simple. You do not know what these are. So for example, if I asked you what is the stock price of IBM one year from now and you know it. Well, good luck to you.

I mean you just don't even need to take this class, all right. That is the challenge you know today's price, but you have no clue about tomorrow's price. In fact, there is a whole concept of market efficiency which says nobody should be able to predict it in a good market, because the value of today's price is based on everything you know about the future. And so if you knew that tomorrow's price was higher or lower, today's price would adjust accordingly and you'll see that why. I think that's just awesome. It's called market efficiency. You can read, you can Google something called Random Vock. It's a very famous concept. It says that stock prices move like randomly. You cannot predict them.

Okay, so today's price be naught. Tomorrow's expected price, P1 and many times if you have e in parenthesis P1. I'm not going to do that. It just makes it messy. Assume that the expected dividend is called D1. And here's the key. Remember I told you, you can't value something without having a bench mark, a relative. Even NPV is based on that. And an idea of evaluation is based on that, right? So for a stock, the dividends are the payment. But how do you value a stock? You will be clueless unless there's a similar stock trading, and you know its expected return. Again I'm not calling it r.

I mean I use the symbol r, but it's expected because nobody knows what it is. Let's assume that the return on a similar stock, similar risk stock, is r. Because there's no point comparing a high risk stock with a low risk stock. What will be true? We just saw, high risk stock will have a high return, so it's unfair to evaluate Kroger, I mean sorry, I'm saying Kroger. Turns out it's a store that you go to in the U.S. and where I live to buy grocery, to buy food. So, he fooled everybody by it, so it's a low risk business.

You can't compare it to say jets or flying in luxury airlines which are a much higher rate of return because they're riskier businesses, okay? Since a stock is very long lived, what we are going to do now, now that you know all the terminology. You know P naught, P1, D1. I'm going to go one period at a time. So, I would mean by last challenge you to do the following. Try to tell me what the price today will be given the information I've given you. Given that I've told you tomorrow's expected price is P1 and tomorrow's expected dividend is D1. And a stock with a similar risk, people can see in the stock market on Yahoo Finance.

So suppose you want to start Moogle, who looks like Google, right? You figure out Google's rate of return. Suppose that's called r. Let's come back in a minute and you tell me what that formula is for the price today given tomorrow's P1 and D1.