Stock Valuation is the process of finding the current worth of an asset. This section describes its methods.
The value approach to value involves finding the intrinsic value of your stock by discounting the future cash flows to the present. The growth approach figures future earnings and growth rates and then compares to your current price.
Firms and Your Rights
A corporation is an artificial economic unit approved by a state. Stock are your ownership or equity in a firm. Because stocks are ownership, when you purchase shares you obtain all the rights of ownership including the right to vote the shares.
But democracy in firms doesn’t work well. Your fellow owners are often widely dispersed, while management and board of directors form a tight unit. Since you have limited say, the rule of thumb and SCM’s policy is ‘vote with your feet’ (sell), if you don’t like what you see.
You purchase stock with the hope of a total return consisting of a cash payout and a gain. The dividend yield is the flow of cash paid by the stock divided by the stock price. The capital gain is the increase in the value of your stock due to the growth in earnings.
Value investing mainly focuses on what an asset is worth– its intrinsic value. As with value of any asset, the value involves bringing future cash flows back to the present at the correct discount rate.
That discount rate is the required rate which is the return you demand to justify buying the stock. This return includes what you may return on a risk-free asset such as a Treasury bill plus an extra bonus for bearing the risk of common stock.
The Dividend-discount Model is a widely used formula in the investment community to calculate a target price incorporating the present value of the stocks cash flows. The inputs are
- current dividend
- growth in earnings/dividends
- your required rate of return
Required Return and Valuation
The beta coefficients are one way to adjust for risk in a valuation model. They are used to specify the risk-adjusted required return.
The required return has two components: the risk-free rate and a risk premium. The risk premium, in turn, is composed of two components: the additional return for investing in equities and the volatility of the particular stock relative to the market as a whole.
The step in evaluating what price you should pay for the stock:
- determine the risk adjusted required return
- use this required return in the dividend discount model to come up with a target price
- compare this valuation with the current price and buy if current price is less than the intrinsic price
Alternate Valuation Techniques
The dividend discount is sound mathematically but doesn’t always work, particularly if the stock does not pay a dividend. Also, another problem is selecting the right beta because it shifts. Also, the risk free rate has to have the same time frame as your expected hold period.
Alternatively, PE ratios (price/earnings) stock valuation is analyzed using actual earnings or estimated earnings. Then, these are compared to the stock’s historic ranges and industry/market averages. Difficulty with PEs occurs when defining and estimating earnings.
Other stock valuation measures, such as price to book value and price to sales, have less estimation risk and are handy when the stock is not showing profit. SCM uses the estimated PE compared to the long-term growth rate or PEG ratio. Finally, the expected ranges vary among industrial sectors but are useful in head to head comparisons with peers.
Your key to success in investing is figuring out how to outperform the market while managing your appropriate risk. The distinction is subtle and often overlooked by the financial press and general public. Failure to account for risk is a separation point among professionals.
The efficient market hypothesis suggests you cannot expect to outperform the market consistently on a risk-adjusted basis. The term random walk means price changes are unpredictable and patterns formed are accidental. Since the markets digest information efficiently, it is the unpredictability of new information being revealed to the participants which causes the randomness.
First, the weak form of the theory suggests fundamental analysis will produce superior results but technical analysis will not. Investors who believe in the semi-strong efficient markets suggests the market has incorporated all known information and no amount analysis will produce superior results except insider information. Finally, the strong theory says the price reflect all information but its rationale has never been proven with empirical data.
Also, visit these topics for further detail or return to the Investment Basics page:
The material presented on this Stock Valuation section and other Investment Basics sections adapted from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades of practical experience. Also,see our Site Credits page for Stock Valuation reference sources.