Investment valuation models

There are many models used to attempt to determine the value of a stock. Here we see some of the most common ones.

The dividend discount model is an essential model that relies on the principle mentioned earlier that the value of an asset, including a stock, is the present value of its expected future cash flows. As the dividends are the cash flows from the stock, its price should be the present value of the dividends paid to owner of the stock.

The idea is that if the value obtained from the “DDM” is higher than what the shares are currently trading at, then the stock is undervalued.

Of course the model has the drawback that it doesn’t work for companies that don’t pay dividends.

Earnings per share serves as an indicator of a company’s profitability. It represents the portion of net income for a period attributable to a single share of a company.

Price / Earning ratio (P/E) is a very important ratio shows price of a share dividend by the earnings per share.

Often used to try to decide if a company’s share price is “cheap” or “expensive” given the earnings a company has.

Compared to past levels or industry averages a high radio can mean the price could be too high, or it could indicate that investors feel that the company will increase earnings in the future. Conversely, lower ratios could mean that a company could be undervalued at its current price or that analysts expect earnings to fall.

Return on Equity (ROE) this ratio shows the amount of net income returned as a percentage of shareholders equity (assets minus its total liabilities). Return on equity is a popular measure of profitability as it shows how much profit a company generates with the money shareholders have invested.

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