What is Share valuation model

It is better for you to recognize the value of stock so you will be able to get more return. Even, you have no financial background, you can start to learn about share valuation.

Until now, there are two valuation model methods i.e. Cash flow model and Price Earning Model. The PER is the most popular and easy because just need the ratio and does need appraisal like present value.

First, we explain about present value

According present value, Shares value measure Cash flow relative to discount value. In determine present value, we are hard to find it. Some analyst use interest rate as the discount value. They assume interest value as the minimum return for the investors return. This interest rate is also named cost of equity.

Giving investor with interest rate is not enough. They want higher return than Fed could give (interest rate).Therefore, the analysts find appropriate discount value for the investors. The analysts should consider three things (1) The comfortable of rate return, (ii) The amount of cash flow will receive and when, and (iii) Combine return rate and cash flow to forecast instristic value of stock and compare with market price today.

The common formula is :

P0 = P1/(1+r) + D1/(1+r)

where P = Share price

r = Interest rate

The formula is useful for predicting one year only. If you want predict more than two years, you should add the time period and the formula become

P0 = P2/(1+r) + D2/(1+r) +D1/(1+r)

Predicting second year dividend is difficult moreover longer year dividend. I think this is the weakness of the present value methods.

To simplyfy the formula, the analysts use asumptions like this:

1 The profit year to year is fixed

2 Net profit is dividend

I think we are difficult to find a company with fixed return especially in bad economic condition. Not all company pay dividend from their profit because they have to buy asset, expand market, save money, etc.

But for simplyfying is ok. the formula is :

Po = D/r

To predict more accurate value shares, analyst also attribute growth rate (g) at dividend. They believe dividend payment will change year to year. The formula is :

Po = D/(1+r) + D1 (1+g)/(1+r)2 +... ...+ D1 (1+g) n-1/(1+r)n

If we used n is undefinitive, we can use formula :

Po = D1/(r-g)

Unfortunately finding g is difficult and the determine is subjective. There is no one financial analyst who can count g precisely.

The calculation of g depend on fundamental factor of company. A bad company will get low growth.

The analyst should also consider the stage of company. At least there is three stages growth i.e. growing stage, transition stage and stagnant stage.

Second method is Price to Earning Ratio (PER) which is easy than present value method. In my other lens, I have explained PER. PER measure share price relative to earning per share (EPS).

We can consider add growth rate in PER formula. The formula is PER = [D1/(r-g)]/E1

The ratio is easy to find in website like Google.com, Yahoo.com, Bloomberg.com, etc.