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Stock valuation is the process by which the underlying value of a stock is established on the basis of its forecasted risk and return performance. At any given time, the price of a share of common stock depends on investors’ expectations about the future behavior of the security. A fundamental assertion of finance holds that the value of a stock is based on the present value of its future cash flows. The future cash flows of a company are determined by the expected earnings or the expected dividends or both the expected earnings and dividends. Simply put, the worth of a company is primarily based on the earnings the company will produce in the future. But if we knew what was going to happen in the future, it would not be called the future, would it? Professor Burton Malkiel sums up the dilemma perfectly in his acclaimed book A Random Walk Down Wall Street:
“The most fundamental influence on stock prices is the level and duration of the future growth of earnings and dividends. [However,] future earnings growth is not easily estimated, even by market professionals.” ‒ Burton Malkiel
So, if someone were to ask you, “What is the most important factor in determining the future value of a company?” In a few words, you could respond, “Future earnings!” or, “Future dividends!” But do any of us know what is going to happen in the future? No! So is valuing stock going to be easy? No! In fact, it is downright impossible to know what a company will be worth three, four, or five years from now. The best we can do is calculate imprecise estimates.
If it is so difficult, even for professionals, to predict the values of stocks, we might be tempted to just give up, pack it in, and go home. Why bother? Luckily for us, there are techniques that we will learn that will help tilt the odds in our favor. We know beforehand that our predictions have a very low probability of being correct. However, our predictions will help us identify prudent investments that will help us build wealth slowly but surely over the long term. Stick with us, Rising Investment Gurus!
We are going to embark on the process of security analysis. Security analysis is the process of gathering and organizing information and then using it to determine the value of a share of common stock. We are searching for the intrinsic value of a stock, the underlying or inherent value of a stock, as determined through our security analysis. What is the company worth? The question is, “What security analysis methods or measures does one use to determine the intrinsic value of a company?” Future earnings? Future dividends? Potential capital appreciation? Price/earnings ratio? Financial ratios? Past price performance? Amount of risk? Value is in the eye of the beholder.
There are two major forms of security analysis, fundamental analysis and technical analysis. We will first tackle fundamental analysis. Fundamental analysis is the examination of a firm’s accounting statements and other financial and economic information to assess the economic value of a company’s stock. Examples of some of the fundamentals are: the competitive position of the company, who are their competitors, suppliers, and customers, the growth prospects for company and its market, their profit margins and company earnings, what assets are available, the company’s capital structure, how much debt do they have, how much equity, etc. There are many other measures that are available to examine. Simply put, the value of a stock is influenced by the performance of the company that issued the stock. The fundamental analyst says, “You are buying companies, not stocks.”
Technical analysis is the study of the various forces at work in the marketplace and their effect on stock prices. Those who adhere to technical analysis believe that they can predict the future price of a stock by analyzing the behavior of the stock price’s history or the overall stock market or both. Simply put, the future price of a stock is influenced by factors other than the company’s fundamental future outlook. The technical analyst says, “You are buying stocks, not companies.” We will explore technical analysis much later on.
There are many valuation models. We will cover a few of the more popular and powerful models. In your investing career, you will possibly want to branch out and experiment with others. Alternatively, you may find that the models we discuss here suit your needs. Either way, in the opinion of Your Humble Author, the use of these models will go a long way toward helping you choose prudent, long-term oriented investments that should withstand the test of time. Please keep in mind throughout our discussion that these models are simply crude guides and their results are not guaranteed. The one aspect that we can be fairly certain of is that our predictions will not be correct. Let’s now get started with our first stock valuation models, the Dividend Discount Models.