Valuation of Cash Flows from Stocks

Valuation of Cash Flows from Stocks

Stocks have value only because of the potential cash flows that investors receive. These cash flows can come from any distribution (such as dividends or capital gains realized on sale) that stockholders expect to receive from their share of ownership of the firm, and it is by forecasting and valuing these expected future cash flows that one can judge the investment value of shares.

The value of any asset is determined by the discounted value of all expected future cash flows.

Future cash flows from assets are DISCOUNTED because cash received in the future is not worth as much as cash received in the present. The reasons for discounting are:

1. the innate TIME PREFERENCES of most individuals to enjoy their consumption today rather than wait for tomorrow,

2. PRODUCTIVITY, which allows funds invested today to yield a higher return tomorrow, and

3. INFLATION, which reduces the future purchasing power of cash received in the future.

4. UNCERTAINTY associated with the magnitude of future cash flows.

These factors 1, 2, and 3 also apply to both stocks and bonds and are the foundation of the theory of interest rates. Factor 4 applies primarily to the cash flows from equities.

The fundamental sources of stock valuation are the dividends and earnings of firms.