A New Method for Valuing Common Stocks

Abstract

A new formula for estimating an investor 's expected return -the T-Model-expresses total return in terms of a company's growth rate, its return on equity and its price-book ratio. The model shows that expected return is independent of a company's dividend policy or its current yield. Elaborate adjustments for yield bias are thus unnecessary. The model implies that a low price-book ratio is usually desirable, because lowering the price-book ratio increases expected return if the company's ROE exceeds its growth rate (as is the case for most companies). The price-book ratio by itself, however, is an incomplete estimator of return; variations in g, ROE and industry averages must also be considered. Neither is growth an automatic harbinger of high expected return. Its effect will depend to a great extent on a firm's price-book ratio. Preliminary tests of the T-Model suggest that it can successfully rank stock portfolios according to their future relative performance and may be more successful than the standard dividend discount model in this regard. It is also easier to use and intuitively more appealing than the dividend discount model.