Common Stock Valuation – Fundamental Security Analysis Suggests Two Basic Approaches

Common Stock Valuation.

The fundamental concept of valuation of shares or stocks is that of present value. A study of the present value concept is a sine-qua-non for the evaluation process. Time value of money states that money today is more desirable than those in the future.

Common Stock Valuation.

Fundamental security analysis suggests two basic approaches to the valuation of common stock as given below:

Present value or income capitalization approach:

Commonly known as the capitalization of income method, the present value approach is similar to the discounting process. The future cash inflows generated from the holding common stock are discounted to the present value at an appropriate discount rate some times referred to as investor’s required rate of return.

Price-earning (P/E) ratio or multiplier approach:

The price-earning (P/E) ratio approach is termed as the earnings multiplier approach. A stock is said to be worth some multiple of its future earnings. It implies that an investor or an analyst determines the value of a stock by deciding how much money he is willing to pay for every unit of money of estimated earnings.

Present Value Approach

The fundamental analysis suggests that the classic method of estimating intrinsic value involves the present value concept. Under this method, the value of a share can be determined by a present value process involving the capitalization of expected future cash inflows. Therefore, the intrinsic value of a share is equal to the sum of the discounted values of the future stream of cash inflows an investor expects to receive from the share which can be determined as:

_n

P₀ = ∑ FCF_t/(1 + k)^t

                                                     ^{t = 1}

where,

P₀ = price of a share today (present value),

FCF_t = free-cash-inflows at time t and

k = investor’s required rate of return called an appropriate discount rate.

The prerequisites to use this model are:

1. The required rate of return: An appropriate discount rate is the proxy of the investor’s required rate of return. An investor willing to purchase a share must assess the risk that commensurates the expected return. At a given level of risk, and expected rate of return is the minimum rate of return that will be required to induce the investor to invest. It is also considered as the investor’s opportunity cost.
2. Expected cash flows: Amount and the timing of the future stream of cash inflows called free-cash-flows are very important in determining the value of a share. The value of a bond is the present value of any interest payments plus the present value of the bond’s face value that will be received at maturity. Likewise, the value of a share is the present value of all cash flows to be received from the issuer. The stream of cash flows from holding a share consists of the cash dividends received and the future price at which the share can be sold.

Dividend discount model:

It uses the present value model to determine the value of a share. As cash dividends are the cash payments a shareholder receives from a firm, they constitute the foundation of valuation for common stock. Dividend discount model (DDM) asserts that the current price of a share is equal to the discounted value of all future dividends received by the investors.

The value of a share as asserted by DDM can be estimated by the following formula:

P_cs = D₁/(1 + k_cs) + D₂/(1 + k_cs)² + D₃/(1 + k_cs)³ + ………. + D_∞/(1 + k_cs)^∞

_∞

= ∑ D_t/(1 + k_cs)^t

                              ^{t = 1}

where,

P_cs = intrinsic value of a common stock

k_cs = discount rate, investor’s required rate of return or opportunity cost.

D₁, D₂, …, D_∞ = annual dividends expected to be received each year.

To use the DDM for share valuation, the investor has to forecast the future dividends during the holding period. It is not possible on the part of the investor to forecast the expected dividends accurately. This is why modifications of DDM have been developed to render it useful for the valuation of share.

As in the case of most of the shares, the amount of dividends grows because of the growth of earnings of a company; this phenomenon should be taken into consideration for the valuation purpose. Therefore, the growth rate pattern of dividends should be considered. Different assumptions regarding the growth rate patterns should be made and incorporated into the valuation model.

The assumptions which are commonly used are:

1. Dividends will not grow at all in the future, i.e. the zero growth assumption,
2. Dividends will grow at a constant rate in the future, i.e. the constant growth assumption,
3. Dividends will grow at varying rates in the future, i.e. the multiple growth assumptions.

Common Stock Valuation – Fundamental Security Analysis Suggests Two Basic Approaches