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2023 | OriginalPaper | Chapter

Stock and Equity Valuation: Where Discounting Does Not Work

Author : Zhiqiang Zhang

Published in: Fundamental Problems and Solutions in Finance

Publisher: Springer Nature Singapore

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Abstract

This chapter explores the valuation of common stock or equity. For various reasons, common stock valuation is often supposed to be a solved problem in finance. In fact, there has been no qualified solution for stock valuation so far in mainstream finance. The multiple or ratio (P/E, P/B and P/S) method is not sound in theory; and the Gordon growth model is not feasible in practice! None of them can consider the growth of a stock properly. Deeper discussions reveal even more and bigger surprises, such as positive perpetual growth rate can never exist, DCF (discounting cash flow) method does not work for stock valuation, etc. Of course, a real solution to stock or equity valuation is worked out finally which is sound in theory and feasible in practice. This is a brand-new valuation method––valuation based on required payback period, which can overcome most defects of DCF method or the Gordon growth model, and can rescue or improve fundamentally the multiple or ratio method as well—by enhance both their theoretical soundness and practical valuation power with theoretical or bubble free ratio models.

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previous chapter Discounting and Bond Valuation

next chapter Further Discussion: Is Practice Ahead of Theory? —Based on the Case of Finance

It was originally published by Myron J. Gordon and other scholars in 1956 based heavily on the book titled “The Theory of Investment Value” by John Burr Williams in 1938.

The purpose here is to test the effect of the positive perpetual growth rate, rather than to estimate the growth rate; the accuracy of the estimation is not our main concern.

About 5.965 × 1,000,000,000,000 billion ton.

Kim Gittleson, Can a company live forever? BBC News, New York at http://www.bbc.co.uk/news/business-16611040.

Please note that “their earnings per share over foreseeable future period are growing at 10%, 20% and 30% respectively” is a realistic situation or reasonable estimation, because people usually cannot forecast the earnings over too long in future, do not mention over infinite future.

Here we use the original concept of the payback period rather than the discounted payback period prevailing in many financial books and literature. The discounted payback period is a misleading concept because it incorporates two competing criteria: the required rate of return and the required payback period. In fact, the required payback period is another side of the required rate of return, i.e., the required payback period = 1/ the required rate of return. Thus, the application of the discounted payback period implies that the return (or payback period) requirement is satisfied repeatedly (twice) in the calculation. This makes no sense and is obviously wrong.

The ZZ growth model cannot be abbreviated to “ZZ model”, because there are other models invented by the author, as showed in the rest of this chapter and the following chapters.

Retention ratio is the percentage that a company retains earnings for funding its further operations and investments. The payout ratio is the percentage of the dividends payout in its net income or earnings.

\(\begin{aligned} {\rm{Retention\,Ratio}} & = {\rm{Retained\,Earnings}}/{\rm{Net\,Income}} = {1} - {\rm{Dividend\,Payout\,Ratio}}; \\ {\rm{Payout\,Ratio}} & = {\rm{Dividends\,Payout}}/{\rm{Net\,Income}} = {1} - {\rm{Retention\,Ratio}}. \\ \end{aligned}\)

When g = 0, the earnings per share will keep constant in the future; the ZZ growth model changes its form as: P = nE.

Note that when g = 0, the theoretical P/E model becomes: P/E = n.

Gordon MJ, Shapiro E. Capital equipment analysis: The required rate of profit. Manage Sci 1956;3(1):102–10.

Gordon MJ, Dividends, Earnings and stock prices. Rev Econ Stat. The MIT Press 1959;41(2):99–105.

Gordon MJ. The savings investment and valuation of a corporation. Rev Econ Stat. 1962;44(1):37–51.CrossRef

Zhang Z. Discussion on the relationship between P/E ratio and growth rate - also on issues related to stock pricing, Research on Financial Issues 2008; 1:67–72.

Zhang Z, ZZ financial discovery. University of International Business and Economics Press, Nov 2008.

Zhang Z, Zhao Q. Is there really a positive sustainable growth rate—Fundamental Rethinking on Financial Theory, Contemporary Finance and Economics 2010; 48–58.

Title: Stock and Equity Valuation: Where Discounting Does Not Work
Author: Zhiqiang Zhang
Publisher: Springer Nature Singapore
Book: Fundamental Problems and Solutions in Finance
Print ISBN: 978-981-19-8268-2

Electronic ISBN: 978-981-19-8269-9

Copyright Year: 2023
DOI: https://doi.org/10.1007/978-981-19-8269-9_3