Pricing Firms on the Basis of Fundamentals

Federal Reserve Bank of Atlanta E C O N O M I C R E V I E W First Quarter 2003 P eople often speculate that a particular stock is overpriced, or underpriced, and analysts sometimes issue stock price targets followed abruptly by price “corrections.” A natural question is, What is the right price for a stock? Mergers and acquisitions of firms rely heavily on determining the right or fair price of a stock. One set of strategies to find the right price is to forecast cash flows from a stock market investment and calculate what that income is worth. Roughly speaking, this strategy is what fundamental valuation is all about, and it is the focus of this article. Beyond an overview and illustration of commonly used fundamental valuation techniques, the article will discuss a new valuation approach developed in Kamstra (2001). The discussion will also explore severe market turndowns, such as the tech “bubble” of the late 1990s, to see if market prices reflected gross overvaluation of various stocks compared to the estimated fundamental values. Application of Kamstra (2001) to both blue chip and dot-com firms improves the ability to track market price movements, as will be demonstrated below with applications to BellSouth, Starbucks, Sun Microsystems, Microsoft, Yahoo, and the S&P 500 index. The article first describes fundamental valuation approaches and establishes links between these methods. This review of techniques will draw on practitioner and academic financial literatures as well as the academic accounting literature. The Literature Alarge literature deals with the issue of stock valuation as a function of future cash flows and discount rates. Valuation methods based on fundamental analysis—forecasting future cash flows and discounting them to estimate the value of this income stream—all face the common criticism that these forecasts can be unreliable. Together with assumptions about the firm’s ability to borrow funds and about market efficiency, such forecasts depend on a company’s maintaining its investment and business strategies. Pricing by discounting future cash flows is intuitive, however. The literature on fundamental valuation includes studies from accounting that explore restatements of the discounted dividend model in terms of accounting information (see Feltham and Ohlson 1995; Penman 1996; Burgstahler and Dichev 1997) and finance papers that often start with or derive the discounted dividend model (see Gordon 1962; Rubinstein 1976; Barksy and DeLong 1993; Campbell and Kyle 1993; Donaldson and Kamstra 1996; Chiang, Davidson, and Okuney 1997; Bakshi and Chen 1998). Finally, a literature written largely by practitioners for practitioners typically starts with the discounted dividend model of Gordon (1962) and augments it to allow for more flexibility. A related literature has focused on the question of market efficiency, documenting abnormal return predictability based on earnings, size, and financial statement ratios.1 There is considerable ongoing Pricing Firms on the Basis of Fundamentals