Common stock evaluation - Essay Example

Common Stock Valuation Introduction Common stock evaluation is the determination of the fair market price of a company’s share. This involves calculating the worth of a company’s stock. Share valuation uses two approaches mainly analysis of fundamentals like earnings analysis and analyzing market trends. Stock supply and demand in the financial markets is determined by the market conditions. Stock valuation is similar to bond valuation but difficult as cash flows are uncertain. Common stock valuation is very useful in any company.

It helps shareholders determine the worth of their investment in the business. Stock valuation also enables potential investors gauge the performance and value of stock in the securities market. Establishing the worth of shares helps one make informed investment decision. The managers use this valuation in the analysis of the worth of their business. This information is also useful to creditors in gauging the credit worthiness of a company before advancing credit (Hoover, 2005). The methods commonly used include discounted cash flow (DCF), the P/E method, and the Gordon model.

Discounted Dividend Method (DDM)This method values the share price by use of forecasted dividends and discounting them. When the figure obtained from the DDM is higher to value of shares presently trading then the stock is considered undervalued (Hoover, 2005). Value of Stock = Dividend per share Discount Rate – Dividend Growth rate Zero Growth Rate ModelThis model assumes that the dividend earned from a stock remains constant over time.

It is the cost of equity of a stock on which a standard amount of dividend is calculated in perpetuity. FormulaStock’s Value = Annual Dividends / Required Rate Ke = DIV1 / P0 The growth rate is zero if the company does not employ retained earnings. Here, the company is assumed to have a 100% dividend payout policy. Dividends, therefore, are equal to earnings: Ke = DIV 1 / P0 = EPS1 / P0 The anticipated earnings price (E/P) ratio is the measure of the firm’s cost of equity.

A stock calculated on the zero-growth model can vary in value when the capitalization rate varies as it viewed risk changes (Hoover, 2005). Advantage It measures cost of equity of a company as all earnings are earned as dividends.DisadvantageThe company’s dividends are assumed constant, and this is not practical. The company is assumed to have a 100% dividend payout policy, which is unrealistic, as most firms have retained earnings.Constant growth model Also, known as Gordon Growth approach and it presumes that dividends grow at a given rate annually, Stock Value (P) = D k- GWhere: D = Expected dividend per share at Year 1k = required rate of return for equity investorG = Growth rate in dividends (in perpetuity) The constant-growth method is essential in valuing stock of stable companies with dividends rising steadily over time.

This model estimates an intrinsic stock value stock using the average dividend growth and forecasting it to dividend rises. The denominator remains the same when the rate of capitalization and dividend growth remains unchanged yearly. The stock’s basic value rises per annum by the proportion of the rise in dividend. Both the share price and the dividend amount will rise by the steady -growth factor, g.Advantages Useful for companies with huge funds inflows and stable dependable leverage trends.

The valuation is easy to perform, as the inputs of data the model are readily available.Disadvantages The model considers only the quantitative and not the qualitative values. Future changes are ignored in calculations. This model is unfavorable for firms and market with quick changing dividend trends.Multiplier ModelThis method involves determination of a company’s stock value from market data.Earnings multiplier =Price/ Earnings Ratio = Current Market Price Expected 12- Month EarningsThis current earnings multiplier indicates the prevailing attitude of investors towards a stock’s value.

AdvantagesNegative earnings generate a useless P/E ratio. The P/E ratios are difficult to analyze and interpret. Management judgment within acceptable accounting principles can alter earnings.DisadvantagesEarnings power is the prime determinant of worth of investment. The P/E ratio is often used in the investment community.ReferenceHoover, S. (2005). Stock valuation: A practical guide to Wall Streets most popular valuation models. New York: McGraw-Hill.