What is stock valuation?

Stock valuation is the process of assigning a dollar value to a given stock. An ideal stock valuation technique would assign an accurate dollar value to all stocks. If a trader purchased a given stock when it traded below its value, the stock price would gradually rise to the 'correct' price at which time the trader would sell the stock and then proceed to buy the next bargain on the list.

No ideal stock valuation techniques exist!!

Stock valuation is an extremely complex topic and no valuation model can truly predict the intrinsic value of a stock. Likewise no valuation model can predict with certainty how the price of a stock will vary in the future. However, valuation models can provide a basis with which to compare the relative merits of two different stocks. Furthermore, some valuation models have been shown statistically to provide above market average returns when 'undervalued' stocks are purchased (this is a topic of hot debate in the academic community).

How is stock value calculated?

A multitude of models exist to value stocks. These models range from relatively simplistic rules of thumb to complex models which extrapolate a stock value from multiple years of earnings estimates. Complex valuation models typically include the following components:

• Book value
• Future earnings
• Dividend rates
• Risk-free rate of return
• Risk of stock
• Time

The book value of the stock represents the current value of the stock. This is typically the most conservative estimate of the stock value. The current book value can be augmented by the predicted future earnings to provide an 'intrinsic' stock value, less any dividends which are paid out to the stockholders. However, most models recognize that these future earnings are not guaranteed and therefore they can not be fully incorporated into the stock value. These models hold that the future returns on a stock are only valuable to the extent that they exceed the 'risk-free' rate of return (typically chosen to match, e.g., a 30 year treasury bond, which is considered a guaranteed return). Thus, these future earnings are discounted both by the risk free rate and by the overall risk which a stock represents.

In addition, it is important to consider the length of time which a given stock will likely exceed the returns of its industry or of the market as a whole. Young growth companies will typically have above average returns for a longer time frame than more established stable companies.

As complex as these models may appear, there are typically only a few variables which can be chosen. The current book value is fixed, as are the future predicted earnings (even though the analysts may be inaccurate, they are typically the only source of information for predicted earnings). The risk-free rate of return is fixed; only the risk-free article is chosen (e.g. the 30 year t-bond rate of return can be referenced at any point in time). Time and perhaps more importantly risk remain as variables which are calculated differently based upon a given valuation model.

The following sections describe the 5 different valuation models which Stockworm supports. It should be noted that these models are of varying complexity, but as an aggregate they do well to represent how the 'average' investor views a stock's value.

Basic EBO model

The Edwards-Bell-Ohlson model is a version of the dividend discount valuation model, which has been reformulated in terms of commonly available fundamental stock data. This model incorporates all of the complex valuation terms which were discussed above. The current 30 year t-bond rate of return is chosen to be the risk-free rate.

The risk of a given stock for the Basic EBO model is chosen to be Beta. The Stockworm-selected time frame for all complex valuation models is chosen to be 10 years.

Levered Beta EBO model

The levered beta EBO model is identical to the Basic EBO model with the exception that the Beta is adjusted for the debt level of the stock under consideration. High debt levels effectively yield a higher risk under this model. A comparison between the Levered Beta and Basic EBO models yields an understanding of how the debt levels of a given stock could affect the intrinsic value of the stock.

Risk Proxy EBO model

The Risk Proxy EBO model discards the traditional measurement of both risk and beta, and instead uses 'proxies' for risk. Risk proxies are parameters which do not feed into stock valuation in a traditional accounting sense, but which investors seem (by their investment choices) to view as indicators of risk. For example, investors seem to view high market capitalization stocks as less risky than small stocks. Other risk proxies used in this model include the number of analysts covering a stock (more = less risky), the debt to market ratio (more debt = more risky), and variation in estimated earnings amongst different analysts (more variation = more risk). It should be emphasized that risk proxies are not necessarily true measures of risk--they are merely a means of quantitating how investors view risk.

PEG Value

PEG based valuation is a simplistic valuation technique which takes advantage of a rule of thumb. This rule states that the P/E ratio of a fairly valued stock should be equal to the growth rate of the stock. Overpriced stocks have higher P/E's and underpriced stocks have lower P/E's than their respective growth rates. 'PEG' is the ratio of P/E compared to growth rate: PEG = (P/E)/(%earnings growth) and PEG Value = Current Price / PEG. It should be noted that the % earnings growth can be expressed as a single year or multiple year's worth of growth (Stockworm uses a three year PEG).

This valuation technique cannot be applied to stocks with negative growth rates.

Forward P/E Value

The forward P/E valuation is another simplistic technique which is based upon a rule of thumb. The rule of thumb is that stocks typically trade at a constant P/E and therefore the 'future' value of a stock can be calculated by comparing the current P/E with the future P/E (as predicated using analysts' estimated earnings for this year). The forward P/E value is calculated as: Price * (P/E,current)/(P/E,future)).

This valuation technique cannot be applied to stocks with negative current or future earnings.