There are several methods used to value companies and their stocks. They attempt to give an estimate of their
fair valueFair value, also called fair price , is a concept used in finance and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:* acquisition/production/distribution costs, replacement costs, or...
, by using fundamental economic criteria. This theoretical valuation has to be perfected with market criteria, as the final purpose is to determine
potential market prices.
The most theoretically sound
stock valuation method, called income valuation or the
discounted cash flowthumb|[[Excel]] spreadsheet uses [[Free cash flow]]s to estimate stock's [[Fair Value]] and measure the sensibility of [[WACC]] and [[Perpetual growth]]...
(
DCF) method, involves
discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposition.
There are several methods used to value companies and their stocks. They attempt to give an estimate of their
fair valueFair value, also called fair price , is a concept used in finance and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:* acquisition/production/distribution costs, replacement costs, or...
, by using fundamental economic criteria. This theoretical valuation has to be perfected with market criteria, as the final purpose is to determine
potential market prices.
Fundamental criteria (fair value)
The most theoretically sound
stock valuation method, called income valuation or the
discounted cash flowthumb|[[Excel]] spreadsheet uses [[Free cash flow]]s to estimate stock's [[Fair Value]] and measure the sensibility of [[WACC]] and [[Perpetual growth]]...
(
DCF) method, involves
discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposition. The discounted rate normally includes a
risk premiumA risk premium is the minimum difference a person requires to be willing to take an uncertain bet, between the expected value of the bet and the certain value that he is indifferent to....
which is commonly based on the
capital asset pricing modelIn finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
.
Approximate valuation approaches
Average growth approximation: Assuming that two stocks have the same
earnings growth-Overview:Generally, the greater the earnings growth, the better.When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate....
, the one with a lower P/E is a better value. The P/E method is perhaps the most commonly used valuation method in the stock brokerage industry. By using comparison firms, a target price/earnings (or P/E) ratio is selected for the company, and then the future earnings of the company are estimated. The valuation's fair price is simply estimated earnings times target P/E. This model is essentially the same model as Gordon's model, if k-g is estimated as the dividend payout ratio (D/E) divided by the target P/E ratio.
Constant growth approximation: The
Gordon modelThe Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that are currently off market. It is named after Myron J. Gordon, who...
or
Gordon's growth model
is the best known of a class of discounted dividend models. It assumes that dividends will increase at a constant growth rate (less than the discount rate) forever. The valuation is given by the formula:
.
and the following table defines each symbol:
| Symbol |
Meaning |
Units |
|
estimated stock price |
$ or € or £ |
|
last dividend Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be paid to the...
paid |
$ or € or £ |
|
discount rate |
% |
|
the growth rate of the dividends -Overview:Generally, the greater the earnings growth, the better.When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate....
|
% |
http://www.fool.co.uk/qualiport/2000/qualiport000628.htm
Limited high-growth period approximation: When a stock has a significantly higher growth rate than its peers, it is sometimes assumed that the
earnings growth-Overview:Generally, the greater the earnings growth, the better.When the dividend payout ratio is the same, the dividend growth rate is equal to the earnings growth rate....
rate will be sustained for a short time (say, 5 years), and then the growth rate will
revert to the meanIn statistics, regression toward the mean refers to the phenomenon that a variable that is extreme on its first measurement will tend to be closer to the centre of the distribution on a later measurement...
. This is probably the most rigorous approximation that is practical .
While these DCF models are commonly used, the uncertainty in these values is hardly ever discussed. Note that the models diverge for
and hence are extremely sensitive to the difference of dividend growth to discount factor. One might argue that an analyst can justify any value (and that
would usually be one close to the current price supporting his call) by fine-tuning the growth/discount assumptions.
Market criteria (potential price)
Some feel that if the stock is listed in a well organized stock market, with a large volume of transactions, the listed price will be close to the estimated fair value. This is called the
efficient market hypothesisIn finance, the efficient-market hypothesis asserts that financial markets are "informationally efficient", or that prices on traded assets already reflect all known information, and instantly change to reflect new information...
.
On the other hand, studies made in the field of
behavioral financeBehavioral economics and behavioral finance are closely related fields that have evolved to be a separate branch of economic and financial analysis which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers,...
tend to show that deviations from the fair price are rather common, and sometimes quite large.
Thus, in addition to fundamental economic criteria, market criteria also have to be taken into account
market-based valuationMarket-based valuation is a form of stock valuation that refers to market indicators, also called "extrinsic" criteria .- Examples of market valuation methods :...
. Valuing a stock is not only to estimate its fair value, but also to determine its
potential price range, taking into account market behavior aspects. One of the behavioral valuation tools is the
stock imageStock image can mean the following:* A stock image in publishing is an image that is commercially available .* A stock image in finance is a stock valuation coefficient based on the "stock profile" , as it is really or as investors perceive it...
, a coefficient that bridges the theoretical fair value and the market price.
On-line valuation calculators
See also
- Stock selection criteria
Stock selection criteria is a strategy in which a stock analyst or investor uses a systematic form of analysis to determine if a particular stock constitutes a good investment and should be added to their portfolio...
- Bond valuation
Bond valuation is the process of determining the fair price of a bond.-Bond valuation:As with any security or capital investment, the fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the value of a bond is determined by discounting the bond's...
- Real estate valuation
Real estate appraisal, property valuation or land valuation is the practice of developing an opinion of the value of real property, usually its Market Value...
- Active portfolio management
Active management refers to a portfolio management strategy where the manager makes specific investments with the goal of outperforming an investment benchmark index...
- List of valuation topics
- Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
- Value at risk
In financial mathematics and financial risk management, Value at Risk is a widely used measure of the risk of loss on a specific portfolio of financial assets...
- Mosaic theory
Mosaic theory in finance is the method used in security analysis to gather information about a corporation. Mosaic theory involves collecting information from different sources, public and private, to calculate the value of security. Applying the mosaic theory is as much art as it is science...
- Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
- Technical analysis
Technical analysis is a security analysis discipline for forecasting the future direction of prices through the study of past market data, primarily price and volume.-History:...
- Fed model
The "Fed model" is a theory of equity valuation used by some security analysts that hypothesizes a relationship between long-term treasury notes and the expected return on equities....
Theory of Equity Valuation
- Undervalued stock
An undervalued stock is defined as a stock that is selling at a price significantly below what is assumed to be its intrinsic value . For example, if a stock is selling for $50, but can be determined to be worth $100 based on predictable future cash flows, then it is an undervalued stock.Numerous...
- John Burr Williams: Theory
External links