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Features of a stock
Generally, a stock represents a unit of ownership in an entity. It represents a package of rights and powers. The examples are the right to receive dividend, voting rights, and the right to receive consideration during the merger, among others. Secondly, the stock is characterized by uncertain returns. For instance, a company may not have adequate earnings to pay dividends. In this case, there will be no return on stocks. Finally, the value of stock is based on cash returns, such as dividends and capital gains. There is no ceiling on this value.
The intrinsic value is a projected true value of an entity, while the market value is the value of the entity that is reflected by the price of its stock. The process of arriving at the intrinsic value of a stock is quite tedious and difficult. However, there are a number of methods that are commonly used to arrive at this value. The market value is often based on external expectations and opinions, while the intrinsic value is verifiable. In most cases, the intrinsic value is always different from the market value.
Approaches of Estimating Value of Common Stock
Under the constant growth model, the intrinsic value of a stock is estimated using the expected future streams of dividend that is assumed to grow at a constant rate. Under this approach, the dividend per share grows at a constant rate in perpetuity. On the other hand, the dividend growth rate is expected to be higher than the average rate, and then it returns to the normal level under the supernormal growth approach. The supernormal growth rate is often arrived at after comparing the performance of the company with the industry averages.
Generally, the risk is the uncertainty that is associated with the outcome of an investment. There are several ways of measuring risk. The most common way of measuring risk is by using a standard deviation. It measures the dispersion from the average values. Other ways of measuring risk are the coefficient of variation, range, alpha, beta, value at risk, conditional value at risk, r-squared, and Sharpe ratio, among others. When making an investment decision, an investor needs to evaluate both the risk and return of the security. Different securities have different levels of risks and returns. Therefore, the investor needs to evaluate the risk-return tradeoff and select a combination that matches their expected return and their attitude towards risks.
Creating a portfolio allows an individual to invest in a variety of assets that have different levels of risk and return. The main reason why an investor needs to create a portfolio is to minimize risk. When done correctly, the total risk of a portfolio is always much lower than that of an individual asset. Constructing a portfolio reduces the correlation between assets. This leads to a reduction of risk of the overall portfolio. Each portfolio has a combination of risk and return of its own. The return of a portfolio depends on the return and the weight of each asset. In some cases, the return of a portfolio is always lower than that of individual asset that has the highest return and higher for assets that have least return.
The risk of a portfolio can be categorized into systematic and unsystematic risk. Unsystematic risk represents a risk that can be reduced and eliminated through diversification. On the other hand, systematic risk cannot be eliminated. The risk is inherent in the entire market or a section of the market. This type of risk is measured using beta.