Product details

While day-to-day stock market prices are largely driven by investors'' emotions, long term they are based on the fundamental values of profits, earnings and cash flows. Most analysts rely on the fundamental building blocks of stock value - the dividends and earnings of firms - to make stock valuation decisions. Stocks have value because of the potential cash flows, called dividends, which a stockholder expects to receive from ownership of the firm. Stocks also have value if, in the future, other stockholders may decide that the valuation of these future dividends is not fully reflected in the future stock price. It is by forecasting and valuing potential future dividends and earnings and deciding whether someone will, in the future value these differently, that enables one to judge the investment value of stocks. Since the future cash flows of bonds are known, the application of net present value techniques, in valuing bonds, is fairly straightforward. The uncertainty of future cash flows makes the pricing of stocks according to net present values more difficult. In this two-part note we examine the valuation principles applicable to stocks. There are two basic approaches to the valuation of common stocks using security analysis. Firstly the present value approach commonly referred to as the capitalisation of income method. This is discussed in the first part. The second approach is the P/E ratio (multiple of earnings) approach, more commonly referred to as fundamental analysis. This approach is described in the second part of this two-part note.