Question

Applying the valuation procedure to common stocks is more difficult than applying it to bonds because:

A) the size and timing of the dividend cash flows are less certain than the coupon payments for bonds.
B) common stocks have no final maturity date.
C) unlike the rate of return, or yield, on bonds, the rate of return on common stock is not directly observable.
D) All of the above are true.

Answer 1

The valuation of common stocks is more difficult than that of bonds because the stock's return is not directly observable and involves predicting future dividends and capital gains. Bonds are less volatile and their valuation relies mainly on interest rate fluctuations, making them simpler to value.

Step-by-step explanation:

Applying the valuation procedure to common stocks is indeed more challenging than it is for bonds. This difficulty arises because the rate of return on common stock is not directly observable as it is for bonds. Investors looking at common stock must consider both potential capital gains from future sales and the dividends that may be paid out.

Fluctuations in stock values can be quite volatile; for instance, the S&P 500 experienced a 26% increase in 2009 after a 37% decline in 2008. The bond market, on the other hand, is influenced mainly by interest rate fluctuations, with less variation in value compared to stocks, but more than savings accounts which change very little year to year.

The calculation of present discounted value for stocks necessarily incorporates assumptions about future benefits and can reflect differing opinions about the prospects of the stock's performance, making it a more subjective determination than the more straightforward valuation of bonds.