STOCK VALUATION

Stock Valuation

Stock Valuation

(a) Stock Valuation

Valuation is the first step toward intelligent investing. When an investor attempts to determine the worth of her shares based on the fundamentals, she can make informed decisions about what stocks to buy or sell. Without fundamental value, one is set adrift in a sea of random short-term price movements and gut feelings.

For years, the financial establishment has promoted the specious notion that valuation should be reserved for experts. Supposedly, only sell-side brokerage analysts have the requisite experience and intestinal fortitude to go out into the churning, swirling market and predict future prices (Palmiter, 2002).

Companies buy shares in other companies for all sorts of reason. Whether it is an outright takeover, in which a company buys all the shares, or a joint venture, in which the company typically buys enough of another company to earn a seat on the board of directors, the stock is always on sale. The price of a stock translates into the price of the company, on sale for seven and a half hours a day, five days a week. It is this information that allows other companies, public or private, to make intelligent business decisions with clear and concise information about what another company's shares might cost them.

Finally, a company can simply repurchase its own shares using its excess cash, rather than paying out dividends to shareholders. This effectively drives up the stock price by providing a buyer as well as improving earnings per share (EPS) comparisons by decreasing the number of shares outstanding. Mature, cash-flow positive companies tend to be much more liberal in this day and age with share repurchases as opposed to dividends, simply because dividends to shareholders get taxed twice (Harvey, 2000).

(b) Collins and Hribar (2000) confirm that trading strategies designed to exploit overreaction of stock prices to the transitory accrual elements of earnings and PEAD are separable and additive in the U.S. market. Our chosen trading strategy exploits the additive nature of these two anomalies. Desai, Rajgopal, and Venkatachamam (2004) report empirical evidence that the separability of the accruals and value {glamour anomalies (of which the Price-Earnings anomaly forms part) depend on whether working capital accruals are included as part of the cash-component of earnings. Since we calculate discretionary accruals from their working capital components we regard them as separate anomalies here. We judge the degree of miss-pricing using the price-earnings (henceforth PE ratio) at the ...