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Charles J. Corrado_Fundamentals of Investments - Chapter 6

CHAPTER 6 Common Stock Valuation A fundamental assertion of finance holds that a security’s value is based on the present value of its future cash flows. Accordingly, common stock valuation attempts the difficult task of predicting the future. Consider that the average dividend yield for large-company stocks is about 2 percent. | CHAPTER 6 Common Stock Valuation A fundamental assertion of finance holds that a security s value is based on the present value of its future cash flows. Accordingly common stock valuation attempts the difficult task of predicting the future. Consider that the average dividend yield for large-company stocks is about 2 percent. This implies that the present value of dividends to be paid over the next 10 years constitutes only a fraction of the stock price. Thus most of the value of a typical stock is derived from dividends to be paid more than 10 years away As a stock market investor not only must you decide which stocks to buy and which stocks to sell but you must also decide when to buy them and when to sell them. In the words of a well-known Kenny Rogers song You gotta know when to hold em and know when to fold em. This task requires a careful appraisal of intrinsic economic value. In this chapter we examine several methods commonly used by financial analysts to assess the economic value of common stocks. These methods are grouped into two categories dividend discount models and price ratio models. After studying these models we provide an analysis of a real company to illustrate the use of the methods discussed in this chapter. 2 Chapter 6 6.1 Security Analysis Be Careful Out There It may seem odd that we start our discussion with an admonition to be careful but in this case we think it is a good idea. The methods we discuss in this chapter are examples of those used by many investors and security analysts to assist in making buy and sell decisions for individual stocks. The basic idea is to identify both undervalued or cheap stocks to buy and overvalued or rich stocks to sell. In practice however many stocks that look cheap may in fact be correctly priced for reasons not immediately apparent to the analyst. Indeed the hallmark of a good analyst is a cautious attitude and a willingness to probe further and deeper before committing to a final investment .