Investor’s investment decisions are based on the valuation of stock which they conducted before making the decision. Generally investors prefer to invest in the undervalued stocks and sell their holding of stocks that they considered to be overvalued. There are many different methods of stock valuation. In addition, there are many factors which increases the risk related to the valuation of the stocks. This paper focuses on the fundamental analysis used for the valuation of the stocks. Fundamental analysis generally use the price earning method, dividend discount model, or free cash flow model for the valuation of the stocks. On contrary to it, we focus on the factors which affect the stock market and valuation of the stocks.
Stock is a security that represents holding in a company and signifies a requisition on the company’s assets and profits ("stock,").
Stock market is a market in which public companies issue or exchange their shares. Stock market is also known as the equity market. Stock market is an crucial part of economy as it provide opportunity for the companies to receive capital from investor in order to give them a part of ownership of the company ("stock market,").
Market risk refers to the risk in which the possibility of an investor to face losses as a result of some factors that influence the performance of the financial market. It can occur in the situation such as recession, fluctuating interest rates ("market risk,").
Methods of stock valuation
Dividend discount model
Free cash flow model
Price earning model
Price-earning (PE) ratio is relatively easy method of stock valuation. It is based on the expected earning instead of recent earning (Madura, 2011). P/E ratio can be defined as the percentage of real stock value and last earning per share. P/E ratio makes comparison easy of the various companies’ performance in a particular industry. P/E ratio of the company, which could not make profit in a specific period, can be calculated. However, it is less reliable (Gottwald, 2012). In addition several variations in this method result in various valuations. There are basically two reasons behind this. First is the earning of the previous year are used as the denominator to predict the future income; however, the past year’s income do not give a right prediction of the coming year earnings. Second, sometime investors use operating income and it create the difference in the valuation of stocks (Gottwald, 2012). We can understand it with the help of an example:
Assume that a company will earn $5 per share in the coming year. And the average proportion of price of share to income of the rivals is 20. Now the value of the company share as folloes:
Per share valuation: EPS * X- PE ratio
= $5 * 20
= $100 (Madura, 2011)
Dividend discount model
In 1931 John B. Williams developed the dividend discount model. It is one of the first models used for pricing...