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Common stocks provide an expected future cash flow stream, and a stock’s value is found in the same manner as the values of other financial assets—namely, as the present value of the expected future cash flow stream. The expected cash flows consist of two elements: (1) the dividends expected in each year and (2) the price investors expect to receive when they sell the stock. The expected final stock price includes the return of the original investment plus an expected capital gain.

We saw in Chapter 1 that managers seek to maximize the values of their firms’ stocks. A manager’s actions affect both the stream of income to investors and the riskiness of that stream. Therefore, managers need to know how alternative actions are likely to affect stock prices. At this point we develop some models to help show how the value of a share of stock is determined. We begin by defining the following terms:

Expected Dividends as the Basis for Stock Values
In our discussion of bonds, we found the value of a bond as the present value of interest payments over the life of the bond plus the present value of the bond’s maturity (or par) value:Stock prices are likewise determined as the present value of a stream of cash flows, and the basic stock valuation equation is similar to the bond valuation equation. What are the cash flows that corporations provide to their stockholders? First, think of yourself as an investor who buys a stock with the intention of holding it (in your family) forever.

Taken From : Five-Minute MBA – Corporate Finance

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