Answer :
The two major approaches used to value stocks are discounted cash flow techniques and relative valuation techniques. Discounted cash flow techniques estimate a stock's value based on its expected future cash flows, while relative valuation techniques compare a stock's value to similar stocks in the market. Both approaches have their strengths and weaknesses, and investors often use a combination of these techniques to make informed investment decisions.
1. Discounted Cash Flow Techniques: This approach involves estimating the present value of a stock based on its expected future cash flows. It takes into account the time value of money, meaning that future cash flows are worth less than the same amount of money received today.
One commonly used discounted cash flow technique is the dividend discount model (DDM), which calculates the present value of expected future dividends.
For example, let's say Company A is expected to pay annual dividends of $1 per share for the next five years. Using the DDM, we would discount these future dividends back to the present using an appropriate discount rate, such as the company's cost of equity. The sum of these discounted dividends would then represent the estimated value of the stock.
2. Relative Valuation Techniques: This approach involves comparing the stock's value to similar stocks in the market. It looks at various financial ratios and multiples, such as the price-to-earnings ratio (P/E ratio), price-to-sales ratio (P/S ratio), or price-to-book ratio (P/B ratio).
The idea is to find comparable companies with similar financial characteristics and use their valuations as a benchmark for the stock in question.
For example, let's say Company B operates in the same industry as Company A and has similar financial metrics. By comparing their P/E ratios, we can determine if Company A is undervalued, overvalued, or fairly valued relative to Company B.
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