¶ … value of common stock? Financial Discovery (2000), report that the following are the five primary methods of estimating the desirability of common stocks. DIVIDEND DISCOUNT METHOD-Users of this method look at the value of a stock as a stream of dividends discounted by a required rate of return. For example, assume a stock pays a constant dividend of $2 per year ($.50 per quarter). If an investor wants to get a 12% per year return from the investment, he or she would pay $2 per .12 or $16.67 for the stock. This example is simplified. Most companies increase their dividends over time. Analysis using this method usually factors in a growth rate for the dividend. In order to evaluate stocks of small, high growth companies, the analyst would have to factor in a higher rate of dividend increases in the early years when the company's earnings are exploding. After this initial period, a more modest dividend growth rate would be employed. Unfortunately, this method is usually too simplified and small errors in estimates of dividend increases can lead to great differences in projected stock prices.
PRICE/EARNINGS RATIO ANALYSIS - Examining the Price/Earnings (P/E) Ratio is one of the most common methods for evaluating stocks. Essentially, this method asks how many times a given year's earnings is an investor willing to pay for a stock. The P/E ratio for stocks varies greatly; just as the earnings, prospects for these companies vary. The better a company's earnings outlook, the higher the P/E ratio should be. If one company's earnings are expected to double over the next couple of years, while most...
Several factors influence P/E ratios. In general, a stock will have a higher P/E if it has strong earnings growth expectations, non-cyclical earnings, a healthy balance sheet, and little regulation and quality management.
EARNINGS MOMENTUM MODELS - These models look at the rate of change of earnings estimates or reported earnings from one period to another. Anticipating the direction of change in earnings estimates is very important to analysts using these momentum models. The best stocks according to this method are those that will be seeing the greatest percentage increase in their earnings estimates.
CASH FLOW MODELS - Cash flow analysis has gained considerable importance over the last decade as companies have restructured and taken on more debt. Many items that affect a company's reported earnings do not influence cash flow. One example of the difference between earnings and cash flow is depreciation. Each year a company has to expense, or writes off, a portion of its plant and equipment until those assets are completely depreciated. Depreciation is subtracted from a firm's earnings. However, depreciation has no effect on cash flow. Since debt and dividends are paid with cash, and not earnings, many analysts concentrate on a company's cash flow.
PRICE/BOOK RATIO ANALYSIS - Some analysts look at a stock's book value per share. This is done by taking the total book value of the firm and dividing that value by the number of shares of stock outstanding.…
