Individuals and companies make an investment because they expect a rate of return over the investment period. Logically, the value of an investment should be equal to the present value of the expected future benefits. For common shares, an analyst can equate benefits to the cash flows to be generated by the investment. The simplest present value model of equity valuation is the dividend discount model (DDM), which specifies cash flows from a common stock investment to be dividends. If the issuing company is assumed to be a going concern, the intrinsic value of a share is the present value of expected future dividends.
Many analysts use more than one type of model to estimate value. Analysts recognize that each model is a simplification of the real world and that there are uncertainties related to model appropriateness and the inputs to the models. The choice of model(s) will depend on the availability of information to input into the model(s) and the analyst’s confidence in the information and in the appropriateness of the model (s).
The stock of a wonderful firm with superior management and strong performance measured by sales and earnings growth can be priced so high that the intrinsic value of the stock is below its current market price and should not be acquired. In contrast, the stock of a company with less success based on its sales and earnings growth may have a stock market price that is below its intrinsic value.
There are two basic methods of valuing equity stock: absolute evaluation and relative evaluation, these methods have its own advantages and disadvantages. Analysts and investors should make wise decisions on the techniques for the asset valuation.
Investment required rate of return is the minimum rate of return that investor accept from an investment to compensate investor for deferring consumption. There are three components for the investment required rate of return: the time value of money during the period of investment, the expected rate of inflation during the period, and the risk involved.
The valuation of securities should consider a firm’s economic and industry environment during the valuation process. Regardless of the qualities or capabilities of a firm and its management, the economic and industry environment will have a major influence on the success of a firm and the realized rate of return on its stock.
The value of an asset is the present value of its expected returns. Specifically, you expect an asset to provide a stream of returns during the period of time you own it. To convert this estimated stream of returns to a value for the security, you must discount this stream at your required rate of return.