Question

Unlike fixed-income securities, there are several different methods for evaluating equity securities which are discussed in this week's text. Please describe, in general, some of these valuation methodologies.

These valuation methods, applied to individual stocks, result in similar, but not necessarily equivalent, valuations. Why is this the case?

Why are the equity markets so closely watched as an economic indicator, and why does the stock market generate so much interest and publicity, seeing as it is dwarfed by the size of the fixed-income market?  

PLEASE GIVE SOURCES MUCH APPRECIATED.

Answer 1

Equity Valuation is different from evaluation of fixed income securities. Consider the below mentioned methodologies for the evaluation of equity securities.

There are two approaches of equity valuation: (1). Absolute Approach, and (2) Relative approach.

(1). Absolute Approach: Absolute stock valuation relies on the historical data that company releases, like, income statement, balance sheet and cashflow statement. Basically it uses fundamental information of companies to evaluate the stock.

The methods used under this approach are, Dividend Discount Model and Discounted cashflow model.

Dividend discount model: This is model used to evaluate a company's stock prices assuming that the current stock price is fairly priced and equals the sum of the company's future dividends.

Discounted Cashflow model: It uses the forecast of the company's unlevered cashflow to value the equity security of the firm.

(2). Relative Approach: In this approach we not only use the fundamental information to value a equity of a firm but also compare the similar firms and their investment opportunities using the financial ratios. The best method to evaluate equity of a firm to use a comparable companies analysis.

Now, coming to the point that the different valuation methods when applied to individual stock results in similar but not equivalent valuations.

There can be some variations in the results obatined from applying these methods, this is because of the approach and the data that we we use to value a equity security.

Different informations have different implications and it affects the valuation results but not significantly. The interpretation (whether to buy or not this stock) that we will make from these valuation approaches will be same.

Now, coming to the next point as why stock market is considered as an indicator of the economy, to understand this we should know two effects that sees it correctly.

Its a debatable topic, and many belived in it. The large decrease in the stock prices indicates about the recession whereas the large increase in it suggests that the economy is going to see a potential growth in future. Like other topics there are many controversies to it.

The theoretical reasons to why stock prices might reflect the future economic growth includes two theories (i). Traditional valuation model of stock prices, and (ii). The wealth effect.

Traditional model model suggests that stock prices reflects the expectations about the future, thus reflect the economic growth.

But according to wealth effect, the fluctuations in the stock market is directly effect on the aggregate spending. Thus economic activity can be predicted by the fluctuations in the stock prices.

Stock market generate so much of interest because it is considered as the main source to finance a firm. Now with the increase of financial literacy people are moving towards investing in companies through stock markets than the traditional investment opportunities.

Stock markets gives high returns than the Bond markets if you are ready to take high risk. with the increase of financial assistance and the analysis of markets and the internet facility, people are moving towards gaining the information about the stock markets and how to invest in it which was earlier difficult for them.

Hence, this is the reason why stock market is still popular than fixed income market.