Valuation Of Firms And Market Expectation-A Research On Model Application

Key Words: Valuation, Model, Application, ResearchThe business objective of a firm is to maximize its value. When this principle is applied to a public-owned company, whose stock price represents an objective evaluation by the public (including its own shareholders)on its value, its stock price can also imply the overall status of the firm in terms of its present and future profitability, time value, risk value as well as the variations of these factors over time. It is therefore a foremost and ultimate goal in corporate financial management to maximize the firm's stock price, which represents the wealth of its shareholders.In corporate financial management, Net Present Value (NPV) represents a most effective way at the decision-making stage of an investment. Its theoretical basis is that the overall value of a firm is constituted of the individual value embodied in each single investment project. The wealth of the shareholder will see increases and the stock price of the firm will rise if all these investments have positive NPVs. This thesis aims to quantify, from an external investor's perspective and using a simplified version of the "Finite Horizon Expected Return Model (FHERM)", the positive NPV projects which are implied in a firm's present stock price and eventually lead to an in-depth analysis of the trend of its business development.A prototype of this valuation model was developed in 1998 by Dr. Danielson of Temple University, U.S.A., but is yet to be demonstrated. In China, most of the researches on the stock market concentrate on the macro fields and valuation of listed companies is mainly based on technical analysis. Basic analysis methods demand more attention both theoretically and practically, i.e. the academic circle and the investment analysis in the stock market. Up to now, no applied valuation model has been offered for the evaluation of listed companies or for the prediction of their future development. This thesis, therefore, aims to demonstrate, with the historical data from some Chinese listed companies, the application of this valuation model through empirical researches.The simplified "Finite Horizon Expected Return Model" can be written as: where 1 + k + ((RN -k) ( = 1 + k andPt=0= The per share stock price at t=0.Et=1= The perpetual cash flow (per share) generated by the firm's assets in place.k = The risk adjusted (real)discount rate.RN= The percentage return on equity from new investments.( = The reinvestment rate: the portion of earnings reinvested in new projects.* = The period of competitive advantage: the number of years the firm can invest the percentage ( of its earnings in positive NPV projects. Positive NPV projects are defined as projects offering returns where: RN-k>0.The above Equation says that the value of a firm is the product of two variables: the present value of the existing assets(E1/k)and the growth multiplier (( ().To quantify the positive NPV investment implied by a firm's stock price, the above equation can be rearranged to write the P/E ratio as a function of ( ( and k.Using this finite growth model, the amount of real growth required to justify a stock price can be estimated in a two step process. First, the model can be used to calculate combinations of RN and ( that are consistent with the stock price. For given values of RN,the model can be used to estimate the period of competitive advantage, (, consistent with the stock price. To solve for (, the above equation can be rewritten as: ln(k(P/E)( = ln(()If require rate of return and reinvestment rate remain constant, the equation says that the period of competitive advantage must last ( years to justify the stock price.As the second step in this process, the implied growth, in real terms, can be calculated for each combination of RN and (. The firm will...