Question

In at least 200 words what is stock valuation, how and why is it used, and why is it important?

Answer 1

Stocks are one of the most widely traded financial assets. The value of a financial asset stems from the value of the cash flows that the asset pays. The most common valuation of stocks, as well as other financial assets, are therefore based on the discounted cash flows. The cash flows of the stock i.e. dividends are discounted at a given rate of return. This rate of return is dependent on the risk of the stock and is directly proportional to the risk. Stock valuation attempts to value a stock in order to arrive at its intrinsic value. This is useful for selling and buying purposes. Without valuation, neither the buyers nor the sellers would know the price and the market would be inefficient.

The various stock valuation models can be clubbed into the following categories:

• The cash flow valuation models such as the dividend growth models. It uses discounted cash flows as discussed above.
• The asset-based valuation models are based on the value of equity that is derived as assets minus liabilities. It may be used for asset-intensive companies or banks.
• The relative valuation models which are based on some ratios or market ratios. Valuations are based on ratios such as PE ratio.