For the purpose of stock valuation, a number of techniques are utilized by different companies. These techniques try to provide an approximation of the fair value of stocks. In doing this, they apply the basic economic standards or benchmarks.
This is basically a theoretical assessment and should be made perfect or complete in terms of market standards. The ultimate aim behind stock valuation is ascertaining potential market prices.
Procedure of stock valuation can be broadly categorized into two types and they are the following:
Fair value or fundamental criteria
According to financial theories, the most reasonable technique for stock valuation is termed as the discounted cash flow method (DCF) and it is also known as income valuation. This method includes the discounting of profits (cash flow, income, or dividend) the share would fetch the shareholder in predictable future periods, as well as a terminal value on sales. Usually, the discount rate contains a risk premium that is generally derived from the Capital Asset Pricing Model (CAPM).
The Gordon’s Growth Model or simply Gordon Model is the most recognized model in the category of discounted dividend models. It presumes that the dividends would grow at a fixed rate of growth (lower in comparison to the discount rate) always. The valuation is expressed with the help of the following formula:
P = D.? ((1+g)/(1+k))i = D.((1+g)/(k-g)), where the summation takes the value of i varying from 1 to ? (infinity).
Here, P refers to the estimated stock price and the units may be US$, UK£, or € (Euro)
D refers to the last dividend paid and the units may be US$, UK£, or € (Euro)
k refers to the discount rate and the unit is %
g refers to the rate of growth of dividends and the unit is %
The Price to Earnings Ratio method is possibly the most frequently applied valuation technique in the business of stock brokerage. Through the implementation of comparison firms, an aimed P/E ratio or Price to Earnings Ratio is chosen for the firm and after that, the future income of the firm is calculated. The fair price of the valuation is plainly calculated by multiplying the aimed Price to Earning Ratio with the anticipated return. This pattern is fundamentally similar to the Gordon’s model in case k-g is computed as the division of dividend payout ratio (D/E) by the aimed Price to Earnings Ratio.
Potential price or market criteria
According to the opinion of a number of people, if a share is registered in a well managed share market and there are huge numbers of transactions, the price that has been enlisted would be near the calculated fair value. This is termed as efficient market hypothesis.
From another point of view, researches done in the area of behavioral finance have a propensity to demonstrate that variations from fair price are quite usual and in some instances, substantially sizable.
Therefore, furthermore to the basic economic standards, market standards also should be taken into consideration for market based valuation. Valuation of a share is not performed solely to calculate the fair value of the share, this is also done for ascertaining the expected price range considering the market conduct characteristics. One of the principal behavioral valuation devices is stock image. This is basically a coefficient, which connects the market value and fair value (theoretical).
Last Updated on : 27th June 2013