Stock Valuation and Investor Expectations

Stock valuation models can be used to guide the investment decisions of institutions or individuals. In the traditional approach, the investor will use a valuation model to calculate a stock’s intrinsic value as a function of the estimated future cash flows the firm will distribute to its shareholders. The investment decision will hinge on how the estimated intrinsic value compares to the current stock price. This approach is appropriate when the investor has access to the detailed company-specific information required to forecast future cash flows. In an alternative approach, the process is reversed, and stock valuation models can be used to identify the cash flow expectations supporting a firm’s current stock price. Depending on whether or not these expectations are reasonable—in light of current and expected firm-specific, industry, and macroeconomic conditions—the investor can decide whether to buy, sell, or hold the stock. This approach is appropriate for external investors who do not have access to detailed company-specific information. This entry discusses the uses and limitations of the most prominent stock valuation models when used in the traditional framework, and explains how to identify and evaluate the expectations embedded within a current stock price.