Valuation is the process of determining the current worth of an asset. The value approach to valuation involves finding the intrinsic value of the stock by discounting the future cash flows to the present. The growth approach estimates future earnings and growth rates and then compares to the current price.
Corporations and Stockholder Rights
A corporation is an artificial economic unit established by a state. Stock represents ownership or equity in a corporation. Because stock represents ownership, investors who purchase shares obtain all the rights of ownership including the right to vote the shares.
But democracy in corporations doesn’t work well. Stockholders are usually widely dispersed, while management and board of directors generally form a cohesive unit. Since a shareholder has limited influence, the rule of thumb and SCM’s policy is ‘vote with your feet’ (sell), if you don’t like what you see.
Investors purchase stock with the anticipation of a total return consisting of a dividend yield and a capital gain. The dividend yield is the flow of dividend income paid by the stock divided by the stock price. The capital gain is the increase in the value of the stock related to the growth in earnings.
Dividend Valuation
Value investing primarily focuses on what an asset is worth– its intrinsic value. As with valuation of any asset, the valuation involves bringing future cash flows back to the present at the appropriate 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 a premium for bearing the risk associated with investments in 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 and the 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 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 first step in evaluating what price you should pay for the stock is to determine the risk adjusted required return. Then, you use this required return in the dividend discount model to come up with a target price. Finally, 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. Another problem is selecting the right beta because it shifts. The risk free rate has to have the same time frame as your expected hold period.
Alternatively PE ratios (price/earnings) are analyzed using actual earnings or estimated earnings. These are compared to the stock’s historic ranges and industry/market averages. Difficulty with PEs occurs with defining earnings and estimating earnings is a daunting task.
Other 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 PE compared to the long-term growth rate or PEG ratio. The expected ranges vary among industrial sectors but useful in head to head comparisons with peers.
Efficient Markets
The key to success in investing is figuring out how to outperform the market while managing the 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 investors 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.
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. The strong theory says the price reflect all information but its rationale has never been proven with empirical data.
Visit these topics for further detail or return to the Investment Basics page:
- Basics Introduction
- Security Markets
- Information Sources
- Risk and Portfolio Theory
- Investment Companies
- Stock Valuation
- Macroeconomic Environment
- Statement Analysis
- Bond Market
- Foreign Securities
The material presented on this page and Investment Basics pages were adapted from Dave’s lecture notes for the Investments for Professionals course taught at UCLA 1998-2005 and three decades of practical experience. See our Site Credits page for reference sources.
