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Stock valuation is one of the major operations made in financial markets. The most interested participants of this process are the investors who have to know the most beneficial targets to pour their money in so that it brings further profits. Intelligent investments are guaranteed with the use of stock evaluation which is a way to calculate all the relevant theoretical values of the existing companies and their stock positions. There are different methods of stock valuation available – the most common ones are price earnings ratio, earnings per share, and the model of Gordon. Many researches find Price Earnings Ratio the most efficient criterion to take decisions on the investment due to the objectiveness of market reaction and the stability indicator that are provided by P/E Ratio (Little, 2007). Other researchers assume that the Gordon Model is applicable due to its simplicity and calculation easiness for mature businesses (Jackson, 1994). Earnings Per Share Ratio is a flexible instrument that may be applied with all kinds of figures – past, present or future (Little, 2010). However, each of the models above has its issues: P/E Ratio does not consider the risks of the company success, the Gordon Model uses only figures and is ignorant of the qualitative factors, and EPS may be too projective and unreliable (Hitchner, 2006). All the researchers agree that no instrument can be applied separately, and the more stock valuation methods are combined, the better it is for the solution reliability of the investor (Van Horne & Wachowicz, 2005). It is essential to remember that the period for all the data used to compare two, three or multiple companies should be the same.
The main purpose of stock evaluation is to forecast the upcoming market prices or generally potential prices in the market niche, and, therefore, to benefit from these changes of price. Overvalued stocks are sold, while the ones that were judged undervalued are bought (Vanhorne, & Wachowicz, 2005). It is grounded by the anticipation of the raise of price for undervalued stocks and the fall of price level for overvalued stocks. The fundamental financial analysis is based upon the predicted intrinsic stock value considering the future cash flows and business profitability. Augment criteria may replace the fundamental analysis. Stock valuation uses predetermined universal formulas that define a variety of economic indicators. There are different methods of stock valuation available – the most common ones are price earnings ratio, earnings per share, and the model of Gordon.
The majority of stock investors and stakeholders assume that Price Earnings Ratio (P/E) is the most significant method of stock valuation to judge a company. Surely, it is not reasonable to sell or buy stocks basing on just one ratio, but P/E is considered to be the most reliable number. P/E is easy to calculate – simply divide the price per share by the earnings per share. It is the investor’s choice what kind of earnings he wants to select – whether it is the level of current earnings, past earnings or prospective earnings, they all give different viewpoints on the stock valuation. It is essential to remember that the period for all the data used to compare two, three or multiple companies should be the same. Price Earnings Ratio indicates the amount of money that the market is ready to pay for each of the company’s shares. For instance, if the ratio exceeds the number of 20, it means that the market is ready to pay 20 times its earnings for the stock. Companies that are more promising in terms of growth and potential generally have a higher P/E, because the investors are more willing to pour their means into the company with higher anticipated profits (Vanhorne, & Wachowicz, 2005). Lower Price Earnings Ratios are typical for high-risk stocks, as the market is not always ready to pay for the higher financial risk.
However, P/E system is not perfect in terms of assigning risk premium to the stocks. The example of high technology markets of the late 1990s demonstrates that in spite of the extremely high premiums offered by the investors, some of these stocks never earned nay profit because of the exaggerated anticipations of the investors. It was a mistake to assume that the growth of hi-tech markets is going to be astronomical. Although some companies did succeed and even overcame the expectations of the investors, many others crashed down taking all the investments with them (Little, 2007). Each individual company should take into account certain abnormalities that may take place – this is especially true with the P/E level of the companies that sell their divisions or real estate. In spite of the numerous faults, Price Earnings Ratio remains one of the investor’s best guides on the way to fair judgment about the stock value. Sometimes it is reasonable to do some benchmarking or compare the results with the companies of the same industry or past periods (Little, 2007). That does not mean that the investor should use only P/E to make his decision about a certain stock value but it is the first bell about whether the investor needs to do more calculations or not.
The Gordon Growth Formula is also frequently applied to find out the stock value. The purpose of this method is to determine the value of stock today, incorporating discounted cash flows, and the present value of a range of future dividends to be paid. The Gordon Growth Formula that is also called Constant Growth Formula makes a suggestion that the company has the same growth rate all the time. The model of Gordon allows seeing the tendency of stock value changes for the infinite number of dividends (Kiley, 2004). The stock value is calculated as the expected dividend per share one year from now divided by the difference between the required rate of return for the equity investor and the growth rate in dividends (or perpetuity). The Gordon Growth Model is somewhat contradictory because of the constant growth assumption, so this method of stock valuation is generally used only for mature companies or broad markets with lower growth levels. There are three inputs that are necessary for the model: the expected dividend level of the stock one year ahead, the assumed rate of the future dividend growth, and the rate of return anticipated by the equity investor. There are several advantages of the Gordon’s model. One of them is the simplicity of calculations and the inputs that are easily accessible (Jackson, 1994). The model can be applied by the most stable and reliable companies of the industry. If the company can be called a mature business and has stable leverage patterns, this is a very useful model. Large-scale real estate companies and financial services can use the model’s guidelines as fair judgment for making decisions on investments.
However, the dividend payments on the average are not as ideal as the Gordon Model assumes, and not so many companies can afford free cash flow to equity (FCFE), which is the ability of the company to pay dividends after covering expenses, debts, and other liabilities (Gordon, 1982). The model’s simplicity is both its advantage and disadvantage at the same time. The focus of it is set on the quantitative characteristics only while the qualitative features are put aside. It is not reasonable to ignore management strategies or branch tendencies, so even a very profitable organization may hold back a part of the upcoming dividend payouts, in order to fund some attractive investment because of the management strategy. This means that the Gordon’s Model is simple but not flexible at all, as the changes in the prospective dividend growth are not considered. The calculation depends on a fantastic assumption that the future dividends grow constantly with the very same speed but this contradicts the reality in many cases. In most cases, even the rapidest growth of dividend payouts may be replaced with slower progress in the nearest future. Certainly, the companies that are characterized by fast rocketed development and dividend growth cannot apply this model, as the dividend payout patterns are very difficult to predict. This is especially applicable in mobile and IT technologies, telecommunications, and software development. Before using the model for stock valuation, the investor has to take into account other factors that are individual for each particular business. It is essential to keep in mind the major characteristics of the market, industry and every company before taking the final decision about this model’s credibility. It is better to switch to the Gordon Model in making simple outline valuations. The investor may also like to combine the Gordon Model calculations with other stock valuation tools or even replace it in case it is not very credible for this particular company. For instance, it is not recommended to apply the model with the companies showing rapid growth or sudden shifts of the leverage. Isolating the calculations retrieved with the Gordon Model would be a sufficient mistake. The investor has to remember that non-quantitative factors are as well very influential for any future dividend valuations.
Earnings per Share Ratio is another significant indicator of the stock value that is somewhat connected to the Price Earnings Ratio discussed above. Earnings per Share Ratio are calculated by dividing the net income or earnings by the average number of shares that outstand in the stock. There are several types of Earnings per Share (EPS). This small classification is very helpful to divide and simplify decision making for the investor. The first variation of EPS is the Trailing EPS that relates to the last year’s figures and the current EPS. This ratio applies only the past four quarters to carry out the calculation. The investor may be pleased with maximum historical accuracy and no suggestions made in this method of stock valuation. It is crucial to comprehend what has already happened but Trailing EPS is not very helpful when the investor wants to learn what the company is going to fulfill in the future. However, if the investor is knowledgeable about the processes that took place in the past, it will be much easier to make decisions and act correspondingly in the future. If the results of the company’s activities were sudden and brought unexpected losses or gains, Trailing EPS won’t be helpful at all. Current EPS uses the figures of this year but they are still projective. The calculations include the four quarters of this fiscal year, and some assumption here is made because the part of the period may be projected. Some quarters or months may not have happened yet but some data is still actual and accurate. Current EPS is the most popular variation because it uses the shortest look into the future possible without ignoring those future activities of the company. Forward EPS ratio is designed to project out for several quarters. The essential characteristic of Forward EPS is how far the projection goes. The accuracy is lost immediately with further-going projections. Each of the ratios may be very effective in evaluating the stock market but the investor or the auditor has to be fair with all the companies compared using the same time periods.
Stock evaluation is always a complicated task set in front of the smart investors, as every single company is a particular case where multiple quantitative and qualitative factors have some weight. The best strategy of stock valuation is combining several strategies simultaneously to ensure the best credibility level of the information retrieved. Price Earnings Ratio, the Gordon Growth Model, Earnings per Share and some other less common methods of stock valuation are extremely effective, and the more instruments the investor involves, the better it is for the reliability of the final decision about the dividend growth and investing.