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Understand How Stocks Are Valued

The goal of stock valuation is to determine the intrinsic value of a company (in other words, the company’s fundamental economic value). If the market price of the company’s stock is greater than the company’s intrinsic value, the investor should sell the stock. If the market price of the company’s stock is less than the company’s intrinsic value, the investor should buy the stock. Determining a company’s intrinsic value is one of the most challenging responsibilities that an investor has. Determining this value is accomplished using various tools, including dividend discount models, fundamental analysis, cash-flow analysis, and technical analysis. Proper stock valuation is a difficult, time-consuming, and challenging activity—it is not something that can be done in a few minutes or a program that can be purchased. The purpose of this section is to familiarize you with some terminology to help you understand stock valuation—not to give you the tools to value stocks. Teaching proper valuation of stocks is beyond the scope of this website.

Dividend discount models: Dividend discount models regard the value of a stock as the present value of all future dividends that will be earned while holding that stock; these dividends are discounted at the company’s required rate of return or discount rate. The value of a company’s common stock is found by dividing the dividend you expect to have in the future by the current required rate of return you require for holding this stock, or discount rate (k), minus the stock’s long-term growth rate (g).

Value of common stock = D1/ ( kg )

The letter g represents how fast you expect the stock to grow over the next fifty years—the long-term growth. It is very difficult to determine the exact value of a company’s stock because you cannot project either the dollar amount of future dividends or the growth rate. However, this model may still be helpful in your stock analysis.

Fundamental analysis: Fundamental analysis assumes that the value of the stock can be determined by the future earnings of the company. Analysts spend a great deal of time investigating the company, the industry, the global industry, and the global economy to determine the intrinsic value of the company and gather the necessary information for fundamental analysis. Fundamental analysis has been found to be a valuable tool for stock valuation, particularly when analysts are able to forecast earnings that are significantly different than the market consensus.

Cash-flow analysis: Cash-flow analysis assumes that the value of the company is measured by the discounted value of the free cash flows to all shareholders, including equity shareholders. Free cash flows are defined as cash flows in addition to cash flows required for operations and investment. To value a stock based on cash-flow analysis, investors build cash-flow models that forecast expected cash flows to all shareholders and to the company as a whole. While cash-flow analysis is helpful in determining intrinsic value, the value of the company often lies in areas that are difficult to quantify in terms of cash flow, such as video libraries, for entertainment companies, or patents, for medical companies.

Technical analysis: Technical analysis assumes that supply and demand are the key factors that are necessary to understand stock prices and markets. Technical analysis focuses on the psychological factors that determine a company’s value, such as greed and fear, as well as the economic factors that determine a company’s value. While major research studies have found that this type of analysis is not as reliable in predicting stock prices, many of the tools used in technical analysis are helpful in managing portfolios, such as price charting, moving average graphs, and other types of price analysis.

In addition to the methods discussed above, a few key ratios are often used to value stocks.

Price-earnings ratio (PE): The PE is the market price of the stock divided by the earnings per share (or the amount you would pay for one dollar of earnings). The PE is one of the most widely used ratios, and it is used to compare the financial performance of different companies, industries, and markets. The PE is most useful when comparing a company’s price earnings to a company’s historical PE (i.e., today’s PE compared to the PE for each of the past 10 years) , the industry PE (i.e., a weighted average of all the PE ratios of companies within an industry), or the market PE (i.e., a weighted average of all the PE ratios of companies within an market). The company’s forecast PE, or the PE for the upcoming year, is generally considered more important than the company’s historical PE or accounting PE.

Price-to-book ratio (PB): The PB is the price of the company’s stock divided by the company’s book value per share. The PB ratio represents the price you are paying for a dollar’s worth of assets, as shown on the balance sheet. The PB does not consider the actual value of the assets, only the nondepreciated portion of the assets; thus, there can often be a major discrepancy between the actual value of the assets and the book value of the assets.

Return on equity (ROE): The ROE is the company’s earnings per share divided by the company’s book values per share. The ROE is a measure of how well the company is utilizing its assets to make money. Generally, the higher this ratio, the better the company is utilizing its resources. Understanding the trend of ROE is important because it indicates whether the company is improving its financial position or not.

Dividend payout ratio: This ratio shows the dividends paid by the company divided by the earnings of the company. The dividend payout ratio can also be calculated as dividends per share divided by earnings per share. A high dividend payout ratio indicates that the company is returning a large percentage of company profits back to the shareholders. A low dividend payout ratio indicates that the company is retaining most of its profits for internal growth. The dividend payout ratio will be different for different types of companies.


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