Common stocks are notoriously difficult to value. Even seasoned finance experts disagree on the price at which a particular stock should trade. While it can also be difficult to value a bond, the exercise is comparatively easier. Such discrepancy is due to the different rights and entitlements of bondholders and stockholders.
Common stock is the most basic ownership unit in a company. The prices you see in the media for the shares of publicly traded companies are the prices for their common shares. While corporations can also issue other types of shares, such as preferred stock or shares with extra voting rights, these are relatively rare. All corporations, however, have common stock, since all corporations must be owned by someone. The common stockholder is entitled to vote in the annual shareholder meeting to elect the company's board of directors. If the board decides to distribute some of the company's earnings to stockholders as dividends, each common stockholder also gets a cash payment.
A bond is a borrowing instrument and can be issued by a corporation; a local authority, such as a municipality; or a government, such as the federal government. Holders of corporate bonds are merely lenders and not owners of a company. They cannot vote in a shareholder meeting, nor can they receive a dividend. Instead, bondholders are entitled to a coupon payment, which is a function of the bond's face value. A bond with a face value of $1,000 and a coupon rate of 7 percent, for example, pays its holder 7 percent of $1,000 or $70 every year. This payment is a legal obligation and not at the discretion of the board of directors. If bondholders do not receive this sum, they can sue the issuing company.
Future Cash Flows
Stocks are far harder to value, because the future cash income associated with a stock is far more difficult to predict. The more profitable the company, the more cash it can distribute to stockholders. There is practically no limit to how high the dividend payments can be. On the other hand, the most a bondholder can receive is the full coupon payment. Just as a bank cannot receive more than it is owed, merely because the borrower is highly profitable, bondholders too cannot get more money than the coupon payment they are promised. When valuing a bond, all that an analyst needs to know is whether the company has sufficient cash to make the bond payments. If it does, the bond's fair value is an objective fact.
The difficulty of putting a dollar value on the intangible benefit of voting rights also makes stock valuation difficult. During critical times, when the shareholders are polarized and the future of the company is in question, for example, the voting rights can be worth a lot. In fact, it is possible to sell the voting rights associated with your shares without giving up the shares themselves. During other times, when the vast majority of shareholders are in agreement about the future direction of the corporation, voting rights might matter little. Predicting when in the future the voting rights will be valuable and how much they will be worth makes stock valuation an inexact science.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.