Do you know the answer to this question?  A lot of professionals on Wall Street would find it difficult to give you a complete answer.  Let’s start the thought process and see if we can arrive at an answer that is complete.  What influences the price of anything?  Supply and demand.  The smaller the supply of an item the higher the price it will have then if there was a greater supply of it in the market.  The greater a demand for an item the higher the price it will command in the market.  OK, that’s the simple stuff, now let us apply it to a share of common stock.

Before we continue let’s make sure we know what a share of common stock is.  A share of common stock is a claim on a company’s earnings and assets.  That doesn’t mean if you own a share of Kraft Foods Inc. (KFT) that you can walk into Kraft and demand that you get a box of their cheesiest macaroni.  Companies issue these claims so that they can raise capital.  Investors then buy them because they expect to have a claim on future earnings through dividend payments.  In theory when a company goes bankrupt and liquidates they should pay out to equity holders, stock holders, for their claim, but equity holders are the last ones paid in a Chapter 11, they are a residual claimant, and by the time it comes to pay them there’s usually nothing left to pay them with.

Imagine that all of the stock market exchanges closed tomorrow and would never reopen.  In this world you would never be able to sell your stock.  You would not want to buy the stock because you think at a later date someone will pay you more money for it, you can no longer sell it!.  So why own it?  You own the stock because of that claim on the company’s earnings, and the dividend payment; which is the company giving you your “share” of that claim on earnings.   Why then would you want to buy stock in a company that is not issuing dividend payments, or are issuing very low ones?  Because in the future you believe that they will issue payments, or if they already are, larger payments.  A company would begin to issue divdiend payments, or larger dividend payments because they are earning more, they are growing or becoming more efficient and thus more profitable.  This is why revenue growth and cost efficency is so important to a company, and why it should be very important to an investor investing in the company.

Let’s come back to the real world where stock exchanges do exist.  And let’s ask the question we started with again, “what influences the price of a stock?”  Supply and demand. We already got that part, but now that we know more we can expand that answer.  Supply influences the price of a stock because the smaller the supply of the outstanding shares of common stock, the greater the stock holder’s “share” of earnings will be, the greater their dividend payment.  There is a demand for common stock because of the claim on earnings that it entails and the dividend payment that comes with that claim.  When the dividend payment increases that is going to increase the demand for the stock.

Compacted answer: the smaller the amount of shares of common stock for the company in the market the greater its price than if there were more shares of the common stock  for the company in the market.  The larger the dividend payment the more expensive a share of common stock will be in the market.

The dividend capitalization model, also known as the dividend growth model, is used to find the cost of equity.  To understand why the dividend capitalization model makes sense and is useful you must understand what influences the price of a stock.  And you must believe that the most important factor that influences the price of a stock is the future dividends that it’ll pay.

The calculation for the dividend capitalization model is as follows:

Cost of Equity = (Dividends per Share (for next year)/Current Market Value of Stock) + Growth Rate of Dividends

Dividends per share are reported in the company’s financial statements, and future ones are always disclosed in news releases.  The current market value of the stock can easily be obtained from places such as google.com/finance or finance.yahoo.com.  However, the growth rate of the dividends is an assumption estimation that you must make when valuing the company.  You can look up in the company’s annual reports the dividends that have been paid year by year by the company up to this point and figure out the growth rate.  This is a good strategy, but keep in mind that past results are not always implications of future results.  Another method would be to look at what the company’s management is prediciting for future dividend payment; remember though that management is often optimistic in their forecasts.  There is no perfect method, that’s why telling the future isn’t easy, even if Miss Cleo claims on her commercials that it is.

The dividend capitalization model is not the only model used for calcuating cost of equity.  The capital asset pricing model, CAPM, is also widely used and often more popular.  Both, however, can be used and often are for discounted cash flow anyalsis, DCF.

The capital asset pricing model ( CAPM ) is used to determine the required rate of return on a security, it is the cost of equity.  When investing in a security an investor expects a certain return.  This expectation comes from the opportunity cost of putting their money in a certain security as opposed to what it could be earning in a different security.  It also comes from the risk is associated with putting their money in that security.  The CAPM seeks to value that opportunity cost and the risk of the specific security to determine what the required rate of return the investor will have to have to invest their money in this security.  Before we go on, let’s exam the model.

The Capital Asset Pricing Model ( CAPM ) is calculated as follows:

r_a = r_f +β_a( r_m - r_f )

Where:

r_a = required rate of return of the security

r_f = risk-free rate

β_a = beta of the security

r_m = return of the market

Now that we have the formula, let’s pick it apart some more and see why it is put together the way it is as well as find where we can obtain the values for these variables.  The risk-free rate, r_f, is in the equation to signify the opportunity cost of what the money that is invested could be earning.  A United States government bond is usually used to represent the risk-free rate.  A US bond only carries risk if the US government no longer exists, because even if the US government does not have the funds they can print more funds or raise taxes.  There is considered to be a certain premium that needs to be paid for being in the market opposed to a risk-free asset like a US bond.  If there was no greater reward for being in the market, then why would you take the greater risk?  That premium is the return of the market, r_m, subtracted by the risk-free rate, r_f, and is referred to as the equity market premium.  The equity market premium needs to be multiplied by the specific security’s beta, β_a,the statisitcal measure of the security’s volatility in comparison to the market, to see what the premium needs to be for this security.  In other words, the equity market premium multiplied against the security’s beta gives you the amount you need to be compensated in order to assume that amount of risk, a risk premium.  Add that premium to the opportunity you are giving up to invest in, the risk-free rate, and you have your required rate of return on that specific security, r_a.

The capital asset pricing model ( CAPM ), however, is not perfect.  Beta is measuring past prices, and the past is not always an indication of the future.  Beta also does not ecompass all of the valuable information of a security.  There are also different ways to calculate a security’s beta, which can lead to varying required rate of returns of a security .  Smaller capitalization stocks also tended to outperform CAPM evaluations, most likely because they are not accuratley captured in the return of the market, r_m.  However, even for its shortcomings CAPM is very useful to calculate the cost of equity and is widely accepted.  Its creators even received a Nobel Prize for it in the sixties, no alternate method has had any such recognition or acceptance.  But, there is an alternative method for calculating the cost of equity, the dividend capitalization model.  CAPM and the dividend capitalization model are both used for Discounted Cash Flow analysis (DCF).

An ETF is a publicly traded fund that is multiple stocks in a certain sector. Each ETF can be made by a different company. Basically, when you buy an ETF it is easier to manage because you will be owning multiple stocks at a time; it is like a mutual fund. This will help you spread out your risk within a certain sector.

I am sure you are wondering the difference between an ETF and a Mutual Fund… There are a few differences that can really make you want to start using ETF’s instead of Mutual funds. Here are a few of the big differences.

1. ETF’s can be bought and sold at any time
2. ETF’s do not have fees like Mutual funds do

When in a mutual fund, say in one day you went up 10% in the middle of the day and put a sell order in, you can’t sell until the very end of the day. This means you might think you will get 10% profit, but the fund could loose ground and you only make 5% because the ending price. Also, mutual funds have high fee prices. It is like buying each stock in that fund indiviually. Imagine the fees you would have at the end of your buying spree, that is basically how high your fees for mutual funds are. Granted that is not all the cases; ETF’s have the normal trading fee of any stock at your broker.

The weighted average cost of capital, WACC, is a calculation used to determine what the firm is paying in interest on their capital, what is their cost of financing.  Their capital, financing, includes all of their equity, i.e. stock, and debt.  Each piece of capital is weighted against its discount proportionally.  For instance, the interest rate on their debt would be multiplied against the amount of debt that they have (as well as their tax rate) to find the weighted average of the debt side of their capital.

The equation for calculating WACC is as follows:

WACC = (E/V)Re + (D/V)Rd(1-Tc)

Where:

E = market value of the firm’s equity

V = the total capital of the firm, equity + debt (E+D)

Re = the cost of equity

D = market value of the firm’s debt

Rd = the cost of debt

Tc = the corporate tax rate

Finding most of the values for these variables is fairly simple, but a few of them can be a little tricky.  E, the market value of the firm’s equity, will be found on the company’s financial statements, add up all the equity accounts.  (Remember these can usually be found on the company’s website under at term similar to “investor relations” or at google.com/finance or finance.yahoo.com.) D, the market value of the firm’s debt, will also be found on the company’s financial statements, add up their liabilities.  Add E and D together and you will get V, which is the value of the firm’s capital, however, not yet appropriately weighted).  E/V is the percentage of the firm’s financing that is done through equity, and E/D is the percentage of the firm’s financing that is done through debt.  Re, the cost of equity, is more difficult to calculate and requires another model.  The capital asset pricing model ( CAPM ) is the most recognized and popular model for calculating the cost of equity and uses beta, risk free rates, and expected market return to calculate.  Another method is the dividend calculation model which uses current dividends being paid by the company’s stock, the current market value of the stock, and the growth rate of those dividend payments.  Rd, the cost of the firm’s debt, is easier to find as it is the current rate they are paying on their debt and should be disclosed.  A company is able to benefit on their taxes from the interest that they pay so it is important to also multiply their debt by 1 minus their tax rate to get a more appropriate valuation, (1-Tc).

Now that you know how to calculate the WACC, it’s valuable to know how to apply it and how to value what you are applying.  Because assumptions have to be made when calculating Re, the cost of equity, (assumptions either about how to calculate the beta or what the dividend growth rate will be) the number one person gets for their calculation of WACC can vary from another’s.  However, WACC still gives you a good idea of at what value cash flows should be discounted at to get their present value.  Another way to think of the WACC is the required return that a company has, as this is what they need generate in order to cover their interest on their financing activites.  The WACC is often used in Discounted Cash Flow anaylsis (DCF) to find the appropriate value to discount the cash flows at for Net Present Value (NPV).