Valuation

Valuation is the attempt to determine whether a stock is fairly priced. According to financial theory, a stock should be valued at the future cash flows it will generate, discounted by an appropriate rate. But both future cash flows and an appropriate discount rate are highly uncertain, and thus investors seek additional valuation methods. The most common valuation method is the price earnings ratio (P/E), which is the price divided by earnings per share (EPS). But this valuation can miss the mark because of accounting vagaries and the time-span chosen for EPS. Moreover, an earnings-based valuation won't work for a new company with loads of promise but no profits as yet. Other recognized valuation methods are similarly useful, and similarly flawed. A valuation based on sales recognizes the firm's revenue-generating power -- but bankrupt firms too often have plenty of revenue. A valuation based on book value uses audited accounting figures, but historical asset values are often wrong. Thus investors tend to use a variety of valuation methods to decide whether the current stock price over- or undervalues a stock.