Valuation There Are a Number of Different

Valuation There are a number of different factors that contribute to a stock's valuation in the market compared with the financial statements. One fundamental difference between the two is that the book value reflects past performance while the market reflects future performance. Book value of the company's equity is determined by the past profit performance of the stock and the amount of debt that the company has.

The market value reflects the investor's expectations of the future cash flows that will accrue from owning one share of the company's stock (No author, 2011). Valuing a firm's equity can be done using a number of techniques, each relying on different assumptions. The first of these is the Gordon growth model (or dividend discount model). This model assumes that stocks are valued based on their intrinsic value alone -- that the value of a company's stock is based only on the known dividend and the historic dividend growth rate (Investopedia, 2011).

An adaptation of this theory holds that expected future dividends are also included, and this explains the value of companies that do not currently pay a dividend -- they are expected to pay one in the future. Another method assumes that total returns are used by investors to calculate the value of a share. The total return consists of both future dividends and future capital gains.

This method will often see the capital asset pricing model put to use in order to understand the relationship between the historical risk of the stock and the expected return it should deliver as a result of that risk (Fama & French, 2004). CAPM is a popular model for analyzing the market value of a company. Another method that is used, at least loosely, in the market is the price/earnings ratio.

The price/earnings ratio is considered to be a measure of growth whereby the higher the P/E ratio is, the more the stock's valuation is based on the assumption of growth. The underlying assumption is that the stock should be worth the current earnings plus whatever growth might occur, so that any valuation above the current earnings per share is the implied growth. An investor in the market will use the P/E ratio to determine if a stock is undervalued, overvalued or fairly valued.

Unlike the dividend discount model or CAPM, the P/E ratio is seldom used to make a determination of a precise share value, but rather to provide a general sense of the stock's valuation. Given these different methods of determining a stock's market value, executives can create value for shareholders in the couple of ways. The first is to increase the dividend, something that would directly reflect the amount of money that shareholders can expect to accrue from their investment.

The other way -- and perhaps the more popular method today -- is to grow the company. Executives grow companies in a couple of different ways. The first is through mergers and acquisitions, where they purchase assets (other companies) and hope to gain more value from the purchase than the cost of the purchase. Doing this assumes that the company's external opportunities are more lucrative than the internal opportunities.