Modern Portfolio Theory and Investment Analysis, 9th Edition

18

The Valuation Process

The search for the “correct” way to value common stocks, or even one that works, has occupied a huge amount of effort over a long period of time. Attempts have ranged from simple mechanical techniques for picking winners to hypotheses about the broad influences affecting stock prices. At one extreme, the attempt to find a simple rule for selecting stocks that will have above-average performance can be likened to the search for a perpetual motion machine. Just as the laws of thermodynamics tell us we cannot build a perpetual motion machine, the theory of efficient markets tells us there is no simple mechanical way to pick winners in the stock market, or at least none that will recover its cost of operation. Yet people continue to spend a disproportionate amount of time on both of these endeavors.

At the other extreme, the determinants of common stock prices are quite easy to specify in general terms. The price of common stock is a function of the level of a company's earnings, dividends, risk, the cost of money, and future growth rate. While it is easy to specify these broad influences, the implementation of a system that uses these concepts to successfully value or select common stocks is a difficult task. This is the task that a valuation model purports to accomplish.

A valuation model is a mechanism that converts a set of forecasts of (or observations on) a series of company and economic variables into a forecast of market value for the company's stock. ...