- By Ankur Sharda, Author of ‘A Guide For Discerning Investor’ available on
Average growth approximation: Assuming that two stocks have the same earningsgrowth, the one with a lower P/E is a better value. The P/E method is perhaps the mostcommonly used valuation method in the stock brokerage industry. By using comparisonfirms, a target price/earnings (or P/E) ratio is selected for the company and then the futureearnings of the company are estimated. The valuation's fair price is simply estimatedearnings times target P/E.Constant growth approximation: It assumes that dividends will increase at a constantgrowth rate (less than the discount rate) forever.
Limited high-growth period approximation
: When a stock has a significantly highergrowth rate than its peers, it is sometimes assumed that the earnings growth rate will besustained for a short time (say, 5 years) and then the growth rate will revert to the mean.This is probably the most rigorous approximation that is practical.
Market criteria (potential price)
Some feel that if the stock is listed in a well organized stock market, with a large volumeof transactions, the listed price will be close to the estimated fair value. This is called
theefficient market hypothesis
. On the other hand, studies made in the field of
behaviouraleconomic or finance
tend to show that deviations from the fair price are rather commonand sometimes quite large. Thus, in addition to fundamental economic criteria, marketcriteria also have to be taken into account market-based valuation. Valuing a stock is notonly to estimate its fair value, but also to determine its potential price range, taking intoaccount market behaviour aspects.Once again to say that all theories are hypothetical and there are conditions applied to it.What can happen in unforeseen future nobody can tell and any estimates done for thefuture can be revised at any given point.One factor strongly affecting a stock’s price is
. All other things beingequal, if a stock’s earnings grow by 20% in a given year, we might expect the stock’sprice to also rise by 20% in order to maintain about the same P/E ratio. So before buyinga stock, we would like to get an idea of how earnings may grow in the next year, twoyears or more. One way would be to look up the analysts’ predictions on future earnings-per-share (EPS) in either free or fee publications. Upto the period of 2 to 3 years one canstill foresee the reasonable rise in EPS. One should always take into consideration onexpansion of company during boom, stable or bust time of a particular industry cycle.Backward integration is one way where company can reduce cost of inputs and boostprofitability whereas in the case of Forward integration, company can boost profit byselling finished goods to consumer.There is also one more important factor to consider is
extra ordinary item
(income orloss) in the balance sheet. It should be excluded while concluding the profits of acompany. Investor should be able to estimate the time of completion of expansion,