A Simplified Approach to Common Stock Valuation

Abstract

As the quest for above-average returns becomes ever more competitive, efficient utilization of resources in money management firms becomes increasingly important. A valuation model derived from the two-stage dividend discount model, but using approximations based on fundamental investment principles, can add efficiency and value by focusing investment resources on those companies that are most likely to offer superior returns in the future. Analysis of the model using ex post data indicates that it can successfully identify the important factors that differentiate superior from inferior performance. The model simplifies the investment process by focusing on two of the most important components in determination of future stock price-earnings growth and price-earnings ratio. Preliminary tests using ex ante data suggest that superior performance at lower or comparable risk levels is achieved from a strategy of purchasing stocks assigned high valuation numbers by the model and avoiding those with low valuation numbers.