Abstract
This chapter finds a new valuation method competitive to the DCF method and further derives a series of valuation models based on the new method. These models solve the key valuation issues in absolute valuation ---- can avoid the ZZ growth paradox trouble, and are flexible enough to value individual stocks in stable sectors and in high-growth sectors. These models solve as well the key valuation issues in relative valuation ---- can find the theoretical valuation ratios (P/E, P/B and P/S) effectively, and measure the bubbles of the individual stocks and the overall market. This chapter finally indicates the vast potentials of this brand new valuation method by demonstrating some basic applications.
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Notes
- 1.
There are a number of variants on the basic P/E ratio based upon how the price and the earnings are defined. For example, apart from the basic P/E ratio, the Forward P/E is also prevailing in stock market, which is defined as the ratio of the current share price to forecasted earnings per share next year. To focus our main intention of searching for solutions to fundamental financial problems, most of the reasoning in this chapter will be based on the basic P/E ratio. Of course, the conclusions are valid too for other P/E variants. For detail, see Aswath Damodaran [2]
- 2.
A Nobel Prize is not awarded posthumously but Fischer Black would undoubtedly have been a joint winner of the 1997 Nobel Prize for Economics had he lived. Black was unfortunately diagnosed with throat cancer in 1994 and died on 30 August 1995.
- 3.
Please note that “their earnings per share over foreseeable future period (such as about 15 years) are 10 %, 20 % and 30 % respectively” is a very realistic situation. For the DCF method, an asset value is the total present value of their future cash flows, including the cash flows over the foreseeable periods and those over the unforeseeable periods. But any assumption beyond the foreseeable period, such as cash flows are nothing or grow at a constant rate, etc. is conceptually unreliable and too arbitrary for valuation hence may result to a too big bias.
- 4.
Here we use the original concept of the payback period rather than the discounted payback period 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 = 1/the required rate of return. Thus the application of the discounted payback period implies that the return requirement is satisfied twice in valuation or decision making. This makes no sense and is definitely wrong.
- 5.
The ZZ growth model cannot be abbreviated to “ZZ model”, because there are other models invented by the author in the rest parts of this chapter and the following chapters.
- 6.
Retention ratio indicates the percentage of a company's earnings that are not paid out in dividends but credited to retained earnings. The payout ratio is the amount of dividends the company
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Earnings/Net Income = 1 − Dividend Payout Ratio
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Payout Ratio = Dividends Payout/Net Income = 1 − Retention Ratio.
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- 7.
When g = 0, the ZZ growth model is: P = nE. .
- 8.
Note that when g = 0, the theoretical P/E model becomes: P/E = n.
- 9.
Based on data from Economic & Social Data Ranking (http://www.dataranking.com), GDP of China in 1985 and 2005 are 305.259 and 2,243.688 respectively. Thus average growth rate is 10.49 %.
- 10.
Based on data from Economic & Social Data Ranking (http://www.dataranking.com), GDP of the US in 1985 and 2005 are 4,220.250 and 12,455.825 respectively. Thus average growth rate is 5.56 %.
References
Gordon MJ (1962) The savings investment and valuation of a corporation. Rev Econ Stat 44(1):37–51
Damodaran A (2006) Damodaran on valuation: security analysis for investment and corporate finance. John Wiley & Sons, Inc
Black F, Scholes M (1973) The pricing of options and corporate liabilities. J Polit Econ 81(3):637–654
Merton R (1973) Theory of rational option pricing. Bell J Econ Manage Sci 4(1):141–183
Cox JC, Ross SA, Rubinstein M (1979) Option pricing: a simplified approach. J Financ Econ 7:229–263
Hull JC (2012) Options, Futures, and Other Derivatives, 8th edn. Pearson Education Limited.
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Zhang, Z. (2013). Valuation Based on Required Payback Period. In: Finance – Fundamental Problems and Solutions. SpringerBriefs in Business. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-30512-2_3
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