Common Stock Valuation
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Written by Atila on September 17, 2008 – 8:07 pm
For many reasons, the valuation of common stocks is a difficult and perplexing process. To begin, the type of valuation model used depends on the characteristics of the firm being valued. In general, there are three distinct types of investor-owned businesses:
1. Start-up businesses. A business in its infancy generally pays no dividends because all earnings must be reinvested in the business to fund growth. To make matters worse, start-up firms often take years to make a profit, so there is no track record of positive earnings to use as a basis for a cash flow forecast. Under such conditions, the general valuation model cannot be applied because the value of such a business stems more from potential opportunities than from existing product or service lines.
Even if most of the opportunities do not materialize, one or two could turn into blockbusters and hence create a highly successful firm. With such firms, option pricing techniques, which are beyond the scope of this book, can be used, at least in theory, to value the stock.
In reality, valuations on these firms are not much more than a shot in the dark, and hence stock prices are based mostly on qualitative factors, including emotions. The end result is that stock prices of such businesses usually are highly volatile.
2. Young businesses. As a firm passes through its initial start-up phase, it often reaches a point where it has more or less predictable positive earnings but still requires reinvestment of these earnings, so no dividends are paid. In such cases, it is possible to value the entire firm, as well as the stock of the firm, on the basis of the expected earnings stream. In such a valuation, the expected earnings stream is discounted, or capitalized, to find the current value of the firm. Then, the value of the debt is stripped off to estimate the value of the common stock.
3. Mature businesses. Mature firms generally pay a relatively predictable dividend, and hence the future dividend stream can be forecasted with reasonable confidence. In such cases, the common stock can be valued on the basis of the present value of the expected dividend stream.
