Stock Valuation

Stock valuation is important part on investment decision. The stock valuation is used to get the intrinsic value or fair value of stock. The information about intrinsic value will be used to decide whether we want to buy or to sell the stock.

There are two ways to calculate the value of stock. The first is using discounted cash flow (DCF) model and comparable multiple approach. The DCF model is based on present value calculation. The value of stock is the present value of expected future cash flows. In investor point of view the cash flows are dividends received from the company and the capital gains/loss.

The comparable multiple approach use the financial ratios to calculate the value/price of stock. The examples of this approach are EBIT Multiple, EBITDA Multiple, Market to Book Value Multiple, and P/E Multiple. When we want to use this approach we must have information about financial ratios from industry or benchmark firms. This approach has several pros and cons.

Pros of multiple approaches:

• Convenient
• Reflects what the market is willing to pay for a comparable firm
• Particularly helpful when firm is not in steady state

Cons of multiple approaches:

• Ignores need to make explicit assumptions regarding long-term profitability and growth
• Subject to market misevaluation
• Subject to accounting distortions
• A relative (rather than absolute) valuation measure
• Difficulty in identifying comparable firms
• Meaningless with negative values
• Denominator may be more cyclical than numerator

CAPM

CAPM stands for Capital Asset Pricing Model. This model tries to relate between return of securities and the risk of the securities. CAPM is developed by Treynor, Sharpe, and Lintner. This model can be used to calculate the value of the securities such as stocks. The idea of this model is that rational investors will demand additional return if they take the additional risk (called risk premium). CAPM decomposes portfolio risk in two categories systematic risk and unsystematic risk (firm risk/unique risk). According this model investor will get compensation from the market because of taking systematic risk from that portfolio. The model of CAPM is

     R_e = R_f + β_e (R_m – R_f)

• R_e = expected return for security
• R_f  = risk-free rate
• R_m = market return
• β_e  = Beta of security (measure systematic risk)

 To get Beta (β_e)  we can use simple regression model. 

     R_e = R_f + β_e (R_m – R_f) + α

     R_e –  R_f  = α  + β_e (R_m – R_f)  

Substitute R_e –  R_f   with Y and R_m – R_f  with X, then we can get simple regression model 

      (R_e –  R_f)  = α  + β_e (R_m – R_f)      

          Y        = α  +      β X 

Agency Problem

Agency problem is the problem or conflict between the management of the company the the owner or principal of the company. The problem or conflict comes from the different interest of management and owner. This problem will affect the performance of the company and also the financial decision of the company such as when the company want to issue the new stock or the new bond.

Besides, the companies must run the business in the best interest of all stakeholders. One of the stakeholders is the shareholder. In order to achive that goal today many companies implement the corporate governance system. The corporate governance system is used to make sure that the management of the company can run the company in the best interest of all stakeholders. Because shareholders are part of stakeholder, therefore the corporate governance system can also reduce the agency problem.