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There are several methods used to value companies and their stocks. They try to give an estimate of their fair value, by using fundamental economic criteria. This theoretical valuation has to be perfected with market criteria, as the final purpose is to determine potential market prices.
Fundamental criteria (fair value)
The most theoretically acceptable stock valuation method, called income valuation or discounted cash flow method, involves discounting the revenues (dividends, earnings, cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposition. The discount rate has to include normally a risk premium.
In some cases an asset valuation is also made. This entails analysing the assets and liabilities of the firm. This type of valuation is typically done if the company is expected to cease operations. It will provide a "termination value" rather than the "ongoing operations value" obtained from the income valuation method.
Market criteria (potential price)
Some feel that if the stock is listed in a well organized stock market, with a large volume of transactions, the listed price will be close to the estimated fair value. This is called the efficient market hypothesis.
On the other hand, studies made in the field of behavioral finance tend to show that deviations from the fair price are rather common, and sometimes quite large.
Thus, in addition to fundamental economic criteria, market criteria also have to be taken into account (market-based valuation). Valuing a stock is not only to estimate its fair value, but also to determine its potential price range, taking into account market behavior aspects. One of the behavioral valuation tools is the stock image, a coefficient that bridges the theoretical fair value and the market price.
See also
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