Characteristics of Variable Income (Common Stock) Securities

Variable Income Securities, also known as equity or common stock, represent ownership in a company and provide the holder with a share of the company’s profits and assets. The value of a stock can be highly variable, and its price is determined by the supply and demand of the stock in the market.

Valuation of variable income securities is often more complex than that of fixed-income securities.

Characteristics of Variable income

Variable income securities, also known as equity or common stock, have the following characteristics:

• Ownership: When you purchase a common stock, you become an owner of the company and have the right to vote on certain corporate matters.
• Risk: Common stock is considered a riskier investment compared to fixed-income securities, such as bonds, because its value is subject to market fluctuations and company performance.
• Volatility: The market value of a common stock can be volatile and can fluctuate greatly depending on various factors, such as economic conditions, company performance, and market sentiment.
• Dividends: Companies may pay dividends to their common stockholders, but the payment is not guaranteed and is at the discretion of the company’s management.
• Capital Appreciation: Common stock can appreciate in value over time, providing the investor with capital gains if sold at a higher price than the purchase price.
• Liquidity: Common stocks are generally more liquid than fixed-income securities and can be bought and sold more easily on a public exchange.
• Yield: Common stock does not have a fixed yield like bonds, but investors may receive a return on their investment through capital appreciation and/or dividends.

Methods used for valuation of common stock are:

Dividend Discount Model (DDM):

This model values a stock based on the present value of future dividends that it is expected to pay out. It assumes that the stock’s value is equal to the present value of all future dividends, discounted at an appropriate rate.

DDM = D1 / (1+r) + D2 / (1+r)^2 + … + Dn / (1+r)^n

where Dn is the dividend expected in year n, and r is the required rate of return.

Alternatively,

DDM = D / (r – g)

where D is the most recent dividend paid

r is the required rate of return

g is the expected growth rate of dividends.

Price-to-Earnings (P/E) Ratio:

This ratio is calculated by dividing the market price per share by the earnings per share. It is a popular method for valuing stocks and is based on the assumption that the stock’s value is proportional to its earnings.

P/E Ratio = Market Price per Share / Earnings per Share

Discounted Cash Flow (DCF) Analysis:

This approach involves estimating the future cash flows that a company is expected to generate and discounting them back to their present value using an appropriate discount rate. The sum of these present values represents the estimated intrinsic value of the stock.

DCF = (CF1 / (1+r)^1) + (CF2 / (1+r)^2) + … + (CFn / (1+r)^n)

Where

CFn is the expected cash flow in year n

r is the required rate of return.

Price-to-Book (P/B) Ratio:

This ratio is calculated by dividing the market price per share by the book value per share. It is used to determine whether a stock is undervalued or overvalued relative to its assets.

P/B Ratio = Market Price per Share / Book Value per Share