Question

how do we value a stock and decide if it is reflective of the actual price we are going to pay for the stock? is there any benchmarks that help measure the risk and associate a return?

answer please

Answer 1

The valuation of stock can be done by using various models and techniques. Some of the widely used models are Price to book ratio, PE ratio, and Dividend Discounting Model

Price to Book Ratio

It represents the value of the company if it is sold today. This is normally used in valuation of companies which have a good value based on their assets. The book value usually includes equipment, buildings, land and anything else that can be sold, including stock holdings and bonds. However the main limitation to this approach is that the book value can fluctuate with the market (in case of financial companies) or with the passage of time (in case of Industrial Companies)

P/B Ratio = Price of the Stock/Book value of Net Assets per share

A company with a lower P/B Ratio would be considered good as it can protect you – but only if it's accurate.

PE Ratio Model

It shows the Ratio of Market Price Per Share to Earnings Per Shares. Suppose the EPS of A Ltd is $5 whereas its shares are traded at $20. So the PE ratio would be 4 times. Now if the industry average in which the company operates is 5 times, it would mean the share are undervalued and vice a versa.

Dividend Discount model

By discounting the expected dividend from the stock the estimated price can be drawn by using investor's risk preferential rate. The formula would be

MPS = D1/(Ke - g)

The D1 is the dividend expected at the end of the year, whereas Ke is the required rate of return. G is the growth rate expected in the dividend.

The dividend-paying stocks are attractive to many investors. When the price are down, some good dividend paying shares generate annual income higher than other class of assets.

Question 2 Benchmark of risk and return

usually the Index of the market e.g. Dow Jones average is used to measure the risk return trade off. The Index will have a beta of 1 which will be compared with the beta of stock. The most common model used for portfolio evaluation is Sharpe Ratio (Which measure the risk adjusted performance)