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Pricing firms on the basis of fundamentals

Listed author(s):
  • Mark Kamstra

Determining the right or fair price of a stock is one of the oldest problems in finance. Business mergers and acquisitions rely on this information, but only in the last several decades have formal models been developed to address the question. This article focuses on fundamental valuation, a technique that determines the right price by forecasting cash flows from a stock market investment and calculating what that income is worth. ; The author first provides an overview of the literature and an illustration of commonly used fundamental valuation techniques based on relative valuation and the Gordon growth model and then discusses a valuation approach he developed in 2001. His work incorporates the proceeds from share liquidation into the cash flows that are used to value the firm, accounting for the reduction in future growth of cash flows from this liquidation of shares. The author demonstrates these methods by applying them to pricing BellSouth shares, the S&P 500 index, and some new-economy stocks. The discussion also looks at prices and estimated fundamental values during severe market turndowns. ; Pricing BellSouth using sales and sales growth is consistent with its dramatic rise and recent decline in price, the author finds; this method is also appropriate for a small group of high-growth stocks. Fundamental models, however, have more trouble explaining the price movements of the overall market. The author concludes that algorithmic valuation techniques provide, at best, a rough starting point for firm valuation.

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Article provided by Federal Reserve Bank of Atlanta in its journal Economic Review.

Volume (Year): (2003)
Issue (Month): Q1 ()
Pages: 49-70

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Handle: RePEc:fip:fedaer:y:2003:i:q1:p:49-70:n:v.88no.1
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  1. Ball, Ray & Watts, Ross L. & Zimmerman, Jerold L., 1987. "The first eight years of the journal of accounting and economics," Journal of Accounting and Economics, Elsevier, vol. 9(1), pages 3-6, April.
  2. Chiang, Raymond & Davidson, Ian & Okunev, John, 1997. "Some further theoretical and empirical implications regarding the relationship between earnings, dividends and stock prices," Journal of Banking & Finance, Elsevier, vol. 21(1), pages 17-35, January.
  3. Brooks, Robert & Helms, Billy, 1990. "An N-Stage, Fractional Period, Quarterly Dividend Discount Model," The Financial Review, Eastern Finance Association, vol. 25(4), pages 651-657, November.
  4. Kirby, Chris, 1997. "Measuring the Predictable Variation in Stock and Bond Returns," Review of Financial Studies, Society for Financial Studies, vol. 10(3), pages 579-630.
  5. Garber, Peter M, 1990. "Famous First Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 35-54, Spring.
  6. Philippe Jorion & William N. Goetzmann, 1999. "Global Stock Markets in the Twentieth Century," Journal of Finance, American Finance Association, vol. 54(3), pages 953-980, June.
  7. John Y. Campbell & Albert S. Kyle, 1993. "Smart Money, Noise Trading and Stock Price Behaviour," Review of Economic Studies, Oxford University Press, vol. 60(1), pages 1-34.
  8. Basu, S, 1977. "Investment Performance of Common Stocks in Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis," Journal of Finance, American Finance Association, vol. 32(3), pages 663-682, June.
  9. Robert B. Barsky & J. Bradford De Long, 1993. "Why Does the Stock Market Fluctuate?," The Quarterly Journal of Economics, Oxford University Press, vol. 108(2), pages 291-311.
  10. Mark Kamstra, 2001. "Rational exuberance: The fundamentals of pricing firms, from blue chip to “dot com”," FRB Atlanta Working Paper 2001-21, Federal Reserve Bank of Atlanta.
  11. Jaffe, Jeffrey & Keim, Donald B & Westerfield, Randolph, 1989. " Earnings Yields, Market Values, and Stock Returns," Journal of Finance, American Finance Association, vol. 44(1), pages 135-148, March.
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