Stock Valuation

Stock Valuation

Bryan Alley, Gabriella Goodfield, Juliano Klein, Shamsuddin Mehri, Chinwe Nwogene

FIN/571

September 21th, 2015

Christopher Kubik

Introduction

Stock valuation is the method used in calculating the total value of a company and their stock. The purpose of these methods is to predict the future market prices, also to profit from price movement like buying stocks that are judged undervalued and selling those stocks that are judged overvalued. With the expectation that the undervalued stocks will rise in value while overvalued stocks will fall. For investors it is very crucial to find a stock at a good entry point. The only way to find a good entry point is to perform some fundamental analysis to find out the appropriate valuation for the stock. So to incorporate valuation into stock strategy they must understand how to value a stock.

                                                        How investors value a stock

When investors valuate stocks, they do it many ways. John Wiley & Sons describe a few of these ways using stock valuation models.  The following are models that they have used:  the One Period Model, the Perpetuity Model, the Genuine Dividend Valuation Model, the Zero Growth Dividend Model, and the Constant Growth Dividend Model.  The One Period Model calculates the present value of the future cash flows.  This is looked at in one period.  The Perpetuity Model basically is the One Period Model but they compare multiple periods in a row.  The Genuine Dividend Model does not try to value the stock over a period of time; it rather calculates the dividends over an infinite period of time.  The Zero Growth Dividend model assumes that the dividends do not grow.  They calculate the dividend payment to be the same throughout time.  Lastly the constant Growth Dividend model is exactly opposite the previous.  It gives the dividend a constant number at which it grows.  Obviously all of these valuation methods are very mathematical in very in depth.  There is no right way to value a stock, each of these methods have their pros and cons.  All can be used for different types of stocks at different times.  

                                                     How Markets Value a Stock

Most of the methods used to determine the value of a stock are based on calculating the net present value of the stream of future cash flows of a company and discounting the expected stream of dividends back whether they will grow or not. Then, the terminal value of the stock is discounted to the value that is expected to sell at the end of the period. The discount rate has to be decided based upon the investor’s perception of the risk of the stream of cash flows. The risk is based upon the company’s business model and the investor interpretation of the business model itself along with its risk. Once that is determined, the investor obtains the stock value the benchmark companies are trading at and compares with the target company. In addition, the investor will make parallel analysis to the available market indices; e.g. S&P 500, Russell 2000 index, etc.; which must be from the same market segment the target company is in; otherwise, the comparison criteria is futile. It is important to choose the index that contains a universe of stocks that match the category of the evaluated stock (John Wiley & Sons, Inc., 2012).