Common Stock Valuation (Intro)
What does the word “value” means? In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller. Now if you are willing to buy a certain stock, how will you know when to buy or if you have purchased a stock, when to sell?
That’s where Stock Valuation comes into play.
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. Mathematically, the value of a stock is determined based on the present value of its future cash flows (a.k.a. earnings).
The expected cash ﬂows consist of two elements: (1) the dividends expected in each year and (2) the price investors expect to receive when they sell the stock. The expected ﬁnal stock price includes the return of the original investment plus an expected capital gain.
The process of gathering and organizing information and then using it to determine the value of a share of common stock. The underlying or inherent value of a stock, as determined through security analysis is called Intrinsic Value.
Security analysis is typically divided into fundamental analysis, which relies upon the examination of fundamental business factors such as financial statements, and technical analysis, which focuses upon price trends and momentum.
We all are aware of the fact that the value of a stock is influenced by the performance of the company that issued the stock. Fundamental analysis basically 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. The information that can be analyzed through fundamental analysis are:
- The competitive position of the company
- Growth prospects for company and its market
- Profit margins and company earnings
- What assets are available?
- The company’s capital structure-How much debt, how much equity
Financial Ratio Analysis.
One method of security analysis involves looking at certain financial ratio measures. Financial ratios give us a quick and easy method for comparing one company to other companies within their industry or the stock market as a whole. The problem with financial ratios is that there is no single financial ratio that can adequately sum up or summarize the overall general state of affairs, situation, predicament, etc. that a company finds itself in.
The first financial ratios we will investigate will be price ratios. We will look at others later on.