What Is the Common Stock Valuation Model?
While common stock value can change over time as business performance improves or worsens, the stock market may rise and fall disproportionately to stock value from time to time, adjusting and correcting trading price along the way. In the long run, stock valuation provides a dependable convention for stock investing, compared with stock prices often supplying unreliable predictions for short-term stock trading. Although it is difficult to foretell stock price, it is possible to model common stock value. Using the common stock valuation model, investors can measure stock risk and make informed investment decisions.
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The Model
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Like any financial asset that bases its value on future monetary benefits, common stock places its value on the future cash flows that its investors expect to receive, namely future dividends from holding the stock and any proceeds when a stock is sold. However, money received in the future cannot be exchanged for today's money in its full amount and must be discounted to an appropriate present value. Two factors affect the so-called discount rate at which future cash flows are reduced to today's value: time value of money and investment rate of return required by investors. In essence, the common stock valuation model is a mathematical formula that calculates a common stock's value by discounting all future cash flows at a specified discount rate.
The Investment Value
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The common stock valuation model provides a reliable benchmark for determining a stock's investment value that is a reflection of a stock's business fundamentals. Cash flows generated from business operations are irrespective of market speculation in the constant trading of its stock. The intrinsic investment value is what investors ought to receive for their investments in the long run. Without such an investment-value perspective, investors may see an increase in potential investment risk when the price investors pay is not bench-marked against its value.
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The Trading Price
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Market trading price can deviate from investment value at times to various degrees. Daily stock trading often is not value oriented, but instead focuses on what other investors might think in terms of future trading prices. Therefore, stocks that are overbought still can be profitable in the short run and stocks oversold may lose further in prices, as long as there are other market participants who also hold the same view on price movement because of the effect of crowd reaction.
The Value-Price Comparison
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The difference between stock value and stock price exists in all market conditions. In an up market, stocks are easily overvalued, and in a down market, stocks are quickly undervalued. By applying the common stock valuation model, investors should buy undervalued stocks and sell overvalued stocks as reflected in market trading prices. But making profits from value-price differential requires a longer investment time frame as price-value correction often takes time until business results can prove any price dislocations.
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