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Friday, August 15, 2008

Approximate valuation approaches

Average growth approximation: Assuming that two stocks have the same earnings growth, the one with a lower P/E is a better value. The P/E method is perhaps the most commonly used valuation method in the stock brokerage industry. By using comparison firms, a target price/earnings (or P/E) ratio is selected for the company, and then the future earnings of the company are estimated. The valuation's fair price is simply estimated earnings times target P/E. This model is essentially the same model as Gordon's model, if k-g is estimated as the dividend payout ratio (D/E) divided by the target P/E ratio.

Constant growth approximation: The Gordon model or Gordon's growth is the best known of a class of discounted dividend models. It assumes that dividends will increase at a constant growth rate (less than the discount rate) forever. The valuation is given by the formula:

P = D\cdot\sum_{i=1}^{\infty}\left(\frac{1+g}{1+k}\right)^{i} = D\cdot\frac{1+g}{k-g}

and the following table defines each symbol:

Symbol Meaning Units
\ P \ estimated stock price $ or € or £
\ D \ last dividend paid $ or € or £
\ k \ discount rate %
\ g the growth rate of the dividends %

Fundamental criteria (fair value)

he most theoretically sound stock valuation method, called income valuation or the discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposition. The discounted rate normally includes a risk premium which is commonly based on the capital asset pricing model.

Stock valuation

here are several methods used to value companies and their stocks. They attempt to give an estimate of their fair value, by using fundamental economic criteria. This theoretical valuation has to be perfected with market criteria, as the final purpose is to determine potential market prices.