Financial options are easier to value than the common stocks to which they relate. Discuss - Essay Example

In case of payment of dividends also, the common stocks are allocated dividends only after the preferred stockholders are paid in full. Thus the valuation of common stock is an area of interest for the investors as it gives an idea of the financial health of the company and also a forecast of the future in terms of profit and loss to be incurred by the company. The valuation of common stock is represented in terms of its present value or fair value or intrinsic value (Moyer, Moyer, McGuigan, Rao and Kretlow, p.249). Financial Options Financial options are contracts which give the right to the owner of the Option to buy or sell an underlying stock at certain agreed upon price within a certain period of time.

The owner of the financial option is, however, not obligated to buy or sell the underlying stock within the specified time frame. The agreed upon price is called the strike price. When the buyer executes the option of buying the underlying security at the strike price, it is called “call” option. When the buyer executes the option of selling the underlying security at the strike price, it is called “put” option. . Financial options are a part of the financial derivatives. The valuation of option depends on the difference between the market price of the underlying security and the strike price and subsequently the discounted expected value of that difference at the time of expiration of the option (Brigham and Ehrhardt, p.273). Valuation: Financial Options and Common Stock The valuation of common stock is based on the determination of present value of the stock taking into account the expected cash flows of the company in future.

The methods applied for valuation of common stock are discounted cash flow method, dividend discount model, etc. The DCF (discounted cash flow model) takes into account the forecasted future cash flows which are determined on the basis of growth rate and terminal growth rate of the company. Factors like depreciation, net profit, capital expenditure, change of working capital, cost of equity as discounting factor is considered for determining the fair value of common stock (Pinto, CFA, Henry, CFA, Robinson, CFA, Stowe and CFA, p.183). The DDM (dividend discount model) for common stock valuation assumes constant payment of dividends by the company.

The model includes forecasting future dividend payout ratio and earnings per share in order to calculate future dividend payments by the company. The determination of present value of common stock is done by discounting the future dividend payments by the cost of equity. The valuation of common stock thus takes into account the expected future cash flows which are affected according to the risk factors. Therefore, valuation of common stock is affected by the company risk, industry risk and market risk.

The company risk and the overall industry risk of common stock could be mitigated by