Approximate Stock Valuation Approaches

There are three key methods for approximate stock valuation. Each try to determine a stock's current value in order to provide insight into the price. If a stock is priced under the perceived value, then it is a good buy. If a stock is priced at or above what an analyst believes its actual value to be, then it is a stock to avoid. Valuing a stock is essential because some "good" stocks, those with a record of high earnings, are actually very over-priced. An investor should look for those stocks that have yet to reach their earnings peak to capitalize on the best opportunities.

Average Growth Approximation

The average growth formula uses a comparison of two or more stocks to determine value. Ideally, two similar types of securities will be used. The two or more stocks an analyst compares will have the same earnings growth, or profit over a period of time. Then, the analyst will use a simple comparison of price to this earnings growth. All other things being equal, the stock with the lower price to earnings (P/E) is a better valued stock. The model can be taken one step further, determining a target P/E for a given company based on comparable stocks. Then, the analyst will compare estimated earnings and target P/E to decide on a fair price today. The formula to find target P/E is mathematically complicated, taking into account the discount rate and growth rate on the dividends. 

Constant Growth Approximation

The constant growth approximation often results in similar answers as the average growth model. It is based on the assumption that dividends will increase at a fairly constant rate forever. The growth rate can be predicted in a formula called Gordon's growth model. Essentially, the model states:

Estimated price = last dividend x (1 + constant growth rate / discount rate - constant growth rate)

Using this model, a fair current price can then be assimilated using estimates of future prices and dividends. This model is particular important when applied to "constant growth stocks," or those which have already posted a substantial record of growth, to determine whether they have become overvalued. 

Limited High-Growth Rate Approximation

This model assumes that a stock with high growth rate will not sustain that high growth forever. In fact, it assumes there is a finite amount of time any stock can hold its price, typically less than five years. The formula takes this one step further to estimate whether a stock is nearing the end of its high growth period or will see a continued amount of growth in the near future. Ideally, an investor will buy in toward the beginning of the growth period. Buying in toward the end means the price may already reflect the value of the stock, not offering much room for capital growth or income. Buying a high growth stock is like buying the nicest home on the block. Either the value can climb because the neighborhood will improve, or the home is already at the top of the market. 

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