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Table of Contents
                            Fundamental criteria (fair value)
	Stock valuation methods
		Earnings per share (EPS)
		Price to Earnings (P/E)
		Growth rate
		Price earnings to growth (PEG) ratio
		Sum of perpetuities method
		Nerbrand Z
		Return on Invested Capital (ROIC)
		Return on Assets (ROA)
		Price to Sales (P/S)
		Market Cap
		Enterprise Value (EV)
		EV to Sales
	Approximate valuation approaches
		Average growth approximation
		Constant growth approximation
		Limited high-growth period approximation
		Implied growth models
Market criteria (potential price)
Keynes’s view
See also
External links
Text and image sources, contributors, and licenses
	Content license
Document Text Contents
Page 1

Stock valuation

In financial markets, stock valuation is the method of
calculating theoretical values of companies and their
stocks. The main use of these methods is to predict fu-
ture market prices, or more generally, potential market
prices, and thus to profit from price movement – stocks
that are judged undervalued (with respect to their the-
oretical value) are bought, while stocks that are judged
overvalued are sold, in the expectation that undervalued
stocks will, on the whole, rise in value, while overvalued
stocks will, on the whole, fall.
In the view of fundamental analysis, stock valuation based
on fundamentals aims to give an estimate of the intrinsic
value of a stock, based on predictions of the future cash
flows and profitability of the business. Fundamental anal-
ysis may be replaced or augmented by market criteria –
what the market will pay for the stock, without any neces-
sary notion of intrinsic value. These can be combined as
“predictions of future cash flows/profits (fundamental)",
together with “what will the market pay for these prof-
its?" These can be seen as “supply and demand” sides –
what underlies the supply (of stock), and what drives the
(market) demand for stock?
In the view of others, such as John Maynard Keynes,
stock valuation is not a prediction but a convention, which
serves to facilitate investment and ensure that stocks are
liquid, despite being underpinned by an illiquid business
and its illiquid investments, such as factories.

1 Fundamental criteria (fair value)

The 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 disposal.[1] The discounted rate normally includes a
risk premium which is commonly based on the capital
asset pricing model.
In July 2010, a Delaware court ruled on appropriate in-
puts to use in discounted cash flow analysis in a dispute
between shareholders and a company over the proper
fair value of the stock. In this case the shareholders’
model provided value of $139 per share and the com-
pany’s model provided $89 per share. Contested inputs
included the terminal growth rate, the equity risk pre-
mium, and beta.[2]

1.1 Stock valuation methods

Stocks have two types of valuations. One is a value cre-
ated using some type of cash flow, sales or fundamen-
tal earnings analysis. The other value is dictated by how
much an investor is willing to pay for a particular share of
stock and by how much other investors are willing to sell
a stock for (in other words, by supply and demand). Both
of these values change over time as investors change the
way they analyze stocks and as they become more or less
confident in the future of stocks.
The fundamental valuation is the valuation that people
use to justify stock prices. The most common example
of this type of valuation methodology is P/E ratio, which
stands for Price to Earnings Ratio. This form of valua-
tion is based on historic ratios and statistics and aims to
assign value to a stock based on measurable attributes.
This form of valuation is typically what drives long-term
stock prices.
The other way stocks are valued is based on supply and
demand. The more people that want to buy the stock,
the higher its price will be. And conversely, the more
people that want to sell the stock, the lower the price will
be. This form of valuation is very hard to understand or
predict, and it often drives the short-term stock market
There are many different ways to value stocks. The key is
to take each approach into account while formulating an
overall opinion of the stock. If the valuation of a company
is lower or higher than other similar stocks, then the next
step would be to determine the reasons.

1.1.1 Earnings per share (EPS)

EPS is the net income available to common sharehold-
ers of the company divided by the number of shares out-
standing. Usually there will be two types of EPS listed: a
GAAP (Generally Accepted Accounting Principles) EPS
and a Pro Forma EPS, which means that the income has
been adjusted to exclude any one time items as well as
some non-cash items like amortization of goodwill or
stock option expenses. The most important thing to look
for in the EPS figure is the overall quality of earnings.
Make sure the company is not trying to manipulate their
EPS numbers to make it look like they are more prof-
itable. Also, look at the growth in EPS over the past sev-
eral quarters / years to understand how volatile their EPS
is, and to see if they are an underachiever or an over-


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debt instead of equity, then the sales per share will seem
high (the P/S will be lower). All things equal, a lower P/S
ratio is better. However, this ratio is best looked at when
comparing more than one company.

1.1.10 Market Cap

Market cap, which is short for market capitalization, is
the value of all of the company’s stock. To measure it,
multiply the current stock price by the fully diluted shares
outstanding. Remember, the market cap is only the value
of the stock. To get a more complete picture, look at the
enterprise value.

1.1.11 Enterprise Value (EV)

Enterprise value is equal to the total value of the com-
pany, as it is trading for on the stock market. To compute
it, add the market cap (see above) and the total net debt of
the company. The total net debt is equal to total long and
short term debt plus accounts payable, minus accounts
receivable, minus cash. The enterprise value is the best
approximation of what a company is worth at any point in
time because it takes into account the actual stock price
instead of balance sheet prices. When analysts say that
a company is a “billion dollar” company, they are often
referring to its total enterprise value. Enterprise value
fluctuates rapidly based on stock price changes.

1.1.12 EV to Sales

This ratio measures the total company value as compared
to its annual sales. A high ratio means that the company’s
value is much more than its sales. To compute it, divide
the EV by the net sales for the last four quarters. This ra-
tio is especially useful when valuing companies that do
not have earnings, or that are going through unusually
rough times. For example, if a company is facing restruc-
turing and it is currently losing money, then the P/E ratio
would be irrelevant. However, by applying an EV to Sales
ratio, one could compute what that company could trade
for when its restructuring is over and its earnings are back
to normal.

1.1.13 EBITDA

EBITDA stands for earnings before interest, taxes, depre-
ciation and amortization. It is one of the best measures
of a company’s cash flow and is used for valuing both
public and private companies. To compute EBITDA, use
a company’s income statement, take the net income and
then add back interest, taxes, depreciation, amortization
and any other non-cash or one-time charges. This leaves
you with a number that approximates how much cash the
company is producing. EBITDA is a very popular figure

because it can easily be compared across companies, even
if not all of the companies are profitable.

1.1.14 EV to EBITDA

This is perhaps one of the best measurements of whether
or not a company is cheap or expensive. To compute,
divide the EV by EBITDA (see above for calculations).
The higher the number, the more expensive the company
is. However, remember that more expensive companies
are often valued higher because they are growing faster
or because they are a higher quality company. With that
said, the best way to use EV/EBITDA is to compare it to
that of other similar companies.

1.2 Approximate valuation approaches

1.2.1 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.[6][7] 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.

1.2.2 Constant growth approximation

TheGordonmodel orGordon’s growthmodel[8] is the best
known of a class of discounted dividend models. It as-
sumes that dividends will increase at a constant growth
rate (less than the discount rate) forever. The valuation is
given by the formula:

P = D ·

1 + g

1 + k

= D ·

1 + g

k − g

and the following table defines each symbol:
Dividend growth rate is not known, but earnings growth
may be used in its place, assuming that the payout ratio is

1.2.3 Limited high-growth period approximation

When a stock has a significantly higher growth rate
than its peers, it is sometimes assumed that the earnings
growth rate will be sustained for a short time (say, 5
years), and then the growth rate will revert to the mean.

Page 6


are thus made 'liquid' for the indi-

— The General Theory, Chapter 12

4 See also
• Stock selection criterion

• Bond valuation

• Real estate appraisal

• Active portfolio management

• List of valuation topics

• Capital asset pricing model

• Value at risk

• Mosaic theory

• Fundamental analysis

• Technical analysis

• Fed model theory of equity valuation

• Undervalued stock

• John Burr Williams: Theory

• Chepakovich valuation model

5 References
[1] William F. Sharpe, “Investments”, Prentice-Hall, 1978,

pp. 300 et.seq.

[2] Delaware Provides Guidance Regarding Discounted Cash
Flow Analysis. Harvard Law School Forum on Corporate
Governance and Financial Regulation.

[3] Brown, Christian; Abraham, Fred (October 2012). “Sum
of PerpetuitiesMethod for Valuing Stock Prices”. Journal
of Economics 38 (1): 59–72. Retrieved 20 October 2012.

[4] Walter, James (March 1956). “Dividend Policies and
Common Stock Prices”. Journal of Finance 11 (1):
29–41. doi:10.1111/j.1540-6261.1956.tb00684.x. Re-
trieved 20 October 2012.

[5] Yee, Kenton K., Earnings Quality and the Equity Risk
Premium: A BenchmarkModel, Contemporary Account-
ing Research, Vol. 23, No. 3, pp. 833-877, Fall 2006 |

[6] Imam, Shahed, Richard Barker and Colin Clubb. 2008.
The Use of ValuationModels by UK Investment Analysts.
European Accounting Review. 17(3):503-535

[7] Demirakos, E. G., Strong, N. and Walker, M. (2004)
What valuation models do analysts use?. Accounting
Horizons 18 , pp. 221-240

[8] Corporate Finance, Stephen Ross, Randolph Westerfield,
and Jeffery Jaffe, Irwin, 1990, pp. 115-130.

[9] Discounted Cash Flow Calculator for Stock Valuation

[10] The Uncomfortable Dance Between V'ers and U'ers, Paul
McCulley, PIMCO

• Stock valuation calculator by P/E values

6 External links

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