Stock Price and Stock Fundamental Value - Essay Example

Stock Price and Stock Fundamental Value Stock Prices And Their Value Introduction Stock in a corporation reflects the equity stake of owners hence always called capital stock. It reflects the investors claim in any business. In a joint-stock company, more than one stakes are brought together to form a shared stock capital. Notably, the price of stock in the stock market reflects the stocks fundamental value. In essence, one cannot remove the pricing from stock valuation, they both reflect market value that helps to understand why prices in the stock market keep flactuating. In stock financial management and pricing, there are few universal truths that affirm that the stock price is a reflection of fundamental value. Valuing Stock Unlike security bonds that have fixed flow of cash, stock is an equity security that guarantees individual shareholders a proportionate ownership in a business. Some of the corporate values that shareholder gets including right to vote and periodic payments from the investment returns called dividends (Ferraro 2009, pg. 10). Like financial assets, the value of the invested stock will be the discounted value of prospective cash flow in the future. Stock fundamental value is reflective of any dividends and the sale price of the stock in the future (Arnold 2007 p.225). One of the cornerstone elements of stock valuation is the Price-to-Earn-Ratio (P/E) it links stock prices changes to the valuation of stock. In the financial market, P/E dictates the prices of stock and the subsequent effect on overall organization stock value. Besides, this ratio shows how long wills a particular stock take to pay back the investor capital if there is stagnation of the business. For instance, a stock trading at $20 with a return of $2 per individual share has a P/E of 10. Essentially, this means that an investor will get the capital invested back (Arnold 2007, p.225). Arnold (2007 p.225) notes that the stock pricing is a cornerstone in valuation of stock. Entrepreneurs values the stock in terms of their ability to return the money invested. Besides, an important financial ratio is Dividend Yield (DY), this identifies return from the investment. The higher the DY, the higher the value of the stock in the market. The critical determinants of DY are purchasing prices and selling prices of a particular stock. Inconsistent and lower dividends reflect low valued stock and thus, poor stock prices in the stock markets. Valuing a stock uses numerous market indexes such as Nasdaq and OTC methods. In each of them, the fundamental value of stock rests on the existing market prices and future prospects. One-Period Model (OPM) perhaps helps to show how stock price indicates fundamental value. In this model, stock is an equity that has discounted value of the dividends while claiming of dividends (Arnold 2007, p.228). Stock Pricing and Valuation In stock market, the decision to sell a stock always reflects the decision to purchase. It, therefore, means the pricing of stock on sales carries certain stock value that compels an entrepreneur to carry comparative price analysis. Because of financial dynamics in the stock market, the stock value at some point always decline. When the value of a particular stock declines, it is reflected by subsequent reduction in prices. Based on the price fluctuation in response to stock value dynamics, it is true that the stock price is the fundamental measure of the stock value (Arnold 2007, p. 226). Secondly, stock prices reacts to the market movement in a consistent pattern. When a particular stock is weak, the prices accompanying goes down. Value of stock is equated in terms of its prices in the market and the future prospects of the industry. Investors, therefore use stock prices pattern over a number of years in order to ascertain the viability of its value in the stock market. It is undeniably true that without stock price displays and consistency in the market, many investors would not purchase. Stock investment value pricing as an integral element that dictates success or loss in the market. Stock price is hence an ultimate reflection of valuation. Thirdly, stock price reflects its value because the stock is what makes a share of ownership of an individual in the company. Being the owner of a stock makes you one of the many shareholders that have invested value in a joint venture. Holding companys stock means paying for a certain proportion of existing stock at the existing market prices. Stock certificate is issued to show ownership of a portion of stock, which in essence reflect the stock value. Stock value depends on the ability to purchase a certain amount of shares in the market (Eberhart 2004, pg.49). Stock returns reflect the value of the investment. I practice, the more stock one owns, the higher the return. Besides, when one invests huge capital into the stock market, the returns are quite high. A wide body of financial literature notes that the return value of stock is 10 to 12% of the invested capital (Arnold 2007, p. 227). Evidently, stock companies pay its stock shareholders profits in the form of dividends. It would have been impossible to estimate the value of dividends of the individual shareholder if the stock prices were non-existence. Besides, the importance of stock ownership rests on the assets and earnings that the stock owner can claim. Investing through stock means putting capital into a shared value whose success depends on the market prices and efficiency of stock brokers (Hirshleifer, 2001, pg.1550). Efficient Market Hypothesis (EMH) in Stock Market Moreover, Efficient Market Hypothesis (EMH) identifies that stock valuation depends on its existing exchange rates in the stock market (Arnold 2007, p.228). It recognizes the difficulty of "beating the market" in an ideal stock market because of pricing and valuation dynamics. Furthermore, EMH states that stock trades at the fairest of their values in the stock exchange thus investors are unlikely to purchase undervalued stock or dispose of stock at inflated price. An important element in EMH is that stock prices are greatest determinants in the market (Zhang 2006, pg.1379). However, some financial analysts argue that some investors like Warren Buffett have in the past consistently beaten market demands that by definition, is impossible under EMH. Others argue that stock pricing may seriously deviate from the actual stock value by citing the Dow Jones Industrial Average (DJIA) price fall of over 20% of the stock value in 1987 (Arnold 2007, p.229). Although, this analysis identifies that the prices of stocks reflect their fundamental values, certain external forces may occasionally destabilize markets prices to deviate from stock value (Barber & Odean, 1999, pg.43). These factors include short-term demand decline due to flooding of alternate viable stock in the market or the industrial recession affecting a particular corporation. Existence of such deviation does not negate the inseparability of stock value and its price. Conclusion Investors decisions are based on existing prices. Under EMH, investors can obtain the highest market prices by buying lowest valued stock in the market in anticipation of increased prices. According to Thaler (1999, pg.15), when price of stock falls considerably, many investors usually avoid purchasing them. Although, it is a riskier thing to do, lowly valued stock has the ability to recover and fetch huge prices. Based on this theory, it is certain that the valuation of stock in the market is solely through pricing. One cannot understand the fundamental value of stock if its prices are delineated. Stock valuation and pricing mechanism are inseparable. Reference List Arnold, G, Essentials of corporate financial management, 2007, Financial Times/Prentice Hall, Chapter 6 (pp. 225-231). Barber, B M. and Odean, T, 1999, aThe courage of misguided convictionsa, Financial Analysts Journal, 55 (6), pp. 41-55. Eberhart, A.C., 2004. Equity Valuation Using Multiples. The Journal of Investing, 13, pp.48–54. Ferraro, S.R., 2009. The buffett approach to valuing stocks. Graziadio Business Report, 12. Hirshleifer, D, 2001, Investor Psychology and Asset Pricing, Journal of Finance, 56(4), pp. 1533- 97. Thaler, R, 1999, The End of Behavioral Finance, Financial Analysts Journal, November- December, pp. 12-17. Zhang, G., 2006. Market Valuation and Employee Stock Options. Management Science, 52, pp.1377–1393. Read More