Stocks and Mutual Funds - Common Stock Valuation Methods
There are two basic approaches to valuing common stock. The first is the fundamental approach, which looks at the actual financial status of the corporation, such as the financial statements we studied in the Quantitative Methods section. The second is the technical approach, which relies on charts and patterns to forecast future stock movements.
- Fundamental analysis
This approach focuses on factors such as:
- Experience of the company's management
- Overall outlook for the industry sector
- Current and pipeline product lines of the company
- Market share
- Balance sheet and income statement
The fundamental analyst tries to assess whether a company's stock is undervalued or overvalued based on its business prospects.
- The dividend discount model (DDM) is a tool used by fundamental analysts to calculate what the market price of a stock should be.
- DDM uses a present value calculation based on a stock's estimated future dividends.
- The stock is considered undervalued if the market price is less than this calculated amount.
- One difficulty of using this model is that projected future dividends may be higher or lower than those that actually occur over time.
The dividend discount model is one of the oldest and most conservative methods of stock valuation. The article Digging Deeper Into the Dividend Discount Model examines the assumptions underlying the DDM.
- Technical analysis
This approach relies on charts and patterns to project the future movements of a particular stock or market index. These are the major measures used by technical analysts:
- Volume - the number of shares trading is considered a signal of strength or weakness. For example, if a stock price increases on strong volume, this is considered more significant than a price increase on weak volume.
- Advance/Decline Ratio - this measures the overall health or "breadth" of the market by comparing the number of issues that increased in price against the number that decreased in price.
- Support and Resistance - this refers to the levels where a stock price comes under pressure. The support level is the "bottom" line in a typical chart, while the resistance level is the "top" line. The following charts illustrate the support and resistance lines for typical stock charts.
Figure 9.1: Support
|Figure 9.2: Resistance
See the Technical Analysis tutorial for an easy-to-understand outlook on the various tools used in technical analysis, including moving averages, relative strength index (RSI), Bollinger bands, stock chart patterns and much more.
Here are two sample exam questions on stock valuation:
- Those who predict stock values based on calculations of the present value of future dividends are using which stock valuation tool?
- Technical analysis
- Dividend correlation model
- Dividend discount model
- Expected return model
The correct answer is "c".
- Using technical analysis, if XYZ stock is trading near its resistance price, it is said to be:
- Head and shoulders
The correct answer is "b". If the stock were trading near its support price, it would be described as oversold.
Investing BasicsThere is no single valuation tactic that works in every situation. But a company’s characteristics provide clues to investors about the best method to use.
ProfessionalsNo one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select the valuation method that best suits the situation
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