The task of selecting stocks can be made easier by organizing the decision process to ensure that salient data and information is evaluated in some logical sequence that allows an investor to make a reasonable decision.
The ultimate goal is to determine, through a range of values, what you think the stock is really worth.
The Valuation Worksheet provides an easy-to-follow systematic format that allows you to walk through the complete process of placing a value on a stock without getting bogged down in complicated financial analysis. However, any final real-world decision would include the further evaluation of other fundamental aspects of the company.
At the bottom of the worksheet, two valuation models are presented, one based on a firm's earnings and the other on its dividends.
The two formulas look different, but they are actually quite similar except for the use of earnings in one and dividends in the other. They equate a stock's price to a stream of future earnings or dividends by asking the question: How much are investors paying for this expected stream?
Both models assume that the growth prospects of the firm have not changed fundamentally over time. The historical relationships between the stock's price and earnings or dividends per share can be used to estimate future value. Then, if current market prices differ significantly from the estimated values based on the historical relationships, it means the market, for whatever reason, is evaluating future income potential differently and may be mispricing the security.
The first approach is for stocks with low or non-existant dividends—the traditional growth stock—and is a price-earnings ratio approach. The price-earnings ratio—share price divided by earnings per share—indicates how much investors are willing to pay for each dollar of the firm's earnings. The higher the ratio, the more investors are paying for earnings, with the expectations that those earnings will increase, or the more confident they are of earnings predictions. Conversely, lower ratios, indicate low earnings expectations, or a low confidence in earnings predictability.
For the earnings valuation, the average annual high and low price-earnings ratios are calculated for prior years. Multiplying these historical ranges by an estimate of next year's earnings per share provides an estimate of future value.
While it may seem difficult to make an earnings estimate, the recent earnings history that is part of the worksheet will give you some basis for forming those expectations. In addition, there are a number of sources where you can obtain analysts' estimates of future earnings, including Value Line and Standard & Poor's and Web sites such as MSN Money and Morningstar.com.
The second approach is primarily for mature, dividend-paying stocks, such as public utilities, which are generally low-growth stocks. It is a dividend-yield approach. Dividend yield—dividends per share divided by share price—is the dividend as a percentage of the stock price. It relates share price to dividends: the lower the dividend yield, the greater the emphasis on earnings growth and disregard for dividend income. The higher the dividend yield, the lower the expectation of earnings growth and the greater the emphasis on dividend income. At the extreme, a high dividend yield may indicate the expectation of a dividend decrease.
This approach requires an estimate of the next expected annual cash dividend. Again, the recent dividend history in the worksheet should provide you with a feel for changes over time, or you can use analysts' estimates.
Dividing the expected annual dividend by the average low dividend yield will give a high-price estimate; dividing the expected annual dividend by the average high dividend yield results in the low-price estimate.
Continue to Step 2 »
