Investors will buy shares in a company when they believe they will receive a return on their investment, either in the form of dividends (that is, regular cash distributions of a corporation's profits) or an appreciation in the value of the stock (that is, they can sell the stock for more tomorrow than they would today). There are different ways that investors typically look to value, or price, a stock. The most common methods price a stock equal to the present value of expected future earnings, cash flow or dividends using the discounted cash flow method. Under these methods, financial analysts look carefully at a corporation's financial statements to determine an appropriate model for forecasting these future amounts. These future amounts are typically discounted at a risky rate of return as determined using the Capital Asset Pricing Model (CAPM).
Dividend Discount Model (Gordon Growth Model)
A common discounted cash flow method that finance students use is the Dividend Discount Model (or Gordon Growth Model). This model assumes that a corporation pays out all its earnings as dividends and that dividends grow at a constant rate in perpetuity. These assumptions do produce some problems with the model; however, it gives students a good sense of how the underlying value of a stock relates to real things such as dividends, and can provide information to increase the accuracy of predictions when other models are used in conjunction. In this model, the value of a stock is worth the sum of all of the discounted future dividend payments.
Where P = the price of the stock
D = the value of the first dividend payment
r = the interest rate, expected rate of return or discount rate
g = the growth rate of the dividends (retention ratio x return on retained earnings)
Many people have heard of terms such as Price-to-Earnings Ratio (P/E Ratio) and Return on Assets. These numbers give us a good idea of how a company is performing. For example, if a stock is trading at $1/share and has an Earnings per Share (EPS) of $0.10, we say it has a P/E Ratio of 10 (1/0.10 = 10). We can then compare it to similar firms, for example, in the same industry, of the same size, and/or with the same capital structure. Now, let's assume these comparative firms are trading at a P/E ratio on average of 5. Given our EPS of $0.10, we may determine that $0.50 ($0.10 x 5 = $0.50) is a more appropriate price for our stock. Similarly, if these comparative firms are trading at P/E Ratios of more than 10, we may conclude that our stock is under priced, and we would want to buy more of it. In this type of analysis, we can use many different types of information on a stock including EPS, P/E Ratios, Return on Capital Invested (ROIC), Return on Assets (ROA), Price to Sales Ratio (P/S Ratio), Earnings (EBITDA, for example), and Earnings to Equity Value Ratio, among the many.
See also: Financial Statement Analysis and Payout, Retention and Growth Ratios