In this chapter, we examined several methods of fundamental analysis used by financial analysts to value common stocks. The methods examined were various dividend discount models, residual income models, and price ratio models. We saw that:

1. Dividend discount models value common stock as the sum of all expected future dividend payments, where the dividends are adjusted for risk and the time value of money.
2. The dividend discount model is often simplified by assuming that dividends will grow at a constant growth rate. A particularly simple form of the dividend discount model is the case in which dividends grow at a constant perpetual growth rate. The simplicity of the constant perpetual growth model makes it the most popular dividend discount model. However, it should be applied only to companies with stable earnings and dividend growth.
3. Dividend models require an estimate of future growth. We described the sustainable growth rate, which is measured as a firm's return on equity times its retention ratio, and illustrated its use.
4. Companies often experience temporary periods of unusually high or low growth, where growth eventually converges to an industry average. In such cases, analysts frequently use a two-stage dividend growth model.
5. The difference between actual and required earnings in any period is called residual income. Residual income is sometimes called Economic Value Added or, sometimes, abnormal earnings.
6. The residual income model is a method that can be used to value a share of stock in a company that does not pay dividends. To derive the residual income model, a series of constant growth assumptions are made for EPS, assets, liabilities, and equity. Together, these growth assumptions result in a sustainable growth rate.
7. The residual income model breaks the value of a share of stock into two parts: the current book value of the firm and the present value of all residual earnings (i.e., income).
8. The clean surplus relationship is an accounting relationship that says earnings minus dividends equals the change in book value per share. The clean surplus relationship might not hold in actual practice. But if the clean surplus relationship is true, then the residual income model is mathematically equivalent to the constant perpetual growth model.
9. Price ratios are widely used by financial analysts. The most popular price ratio is a company's price-earnings ratio. A P/E ratio is calculated as the ratio of a firm's stock price divided by its earnings per share (EPS).
10. Financial analysts often refer to high-P/E stocks as growth stocks and low-P/E stocks as value stocks. In general, companies with high expected earnings growth will have high P/E ratios, which is why high-P/E stocks are referred to as growth stocks. Low-P/E stocks are referred to as value stocks because they are viewed as cheap relative to current earnings.
11. Instead of price-earnings ratios, many analysts prefer to look at price-cash flow (P/CF) ratios. A price-cash flow ratio is measured as a company's stock price divided by its cash flow per share. Most analysts agree that cash flow can provide more information than net income about a company's financial performance.
12. An alternative view of a company's performance is provided by its price-sales (P/S) ratio. A price-sales ratio is calculated as the price of a company's stock divided by its annual sales revenue per share. A price-sales ratio focuses on a company's ability to generate sales growth. A high P/S ratio suggests high sales growth, while a low P/S ratio suggests low sales growth.
13. A basic price ratio for a company is its price-book (P/B) ratio. A price-book ratio is measured as the market value of a company's outstanding common stock divided by its book value of equity. A high P/B ratio suggests that a company is potentially expensive, while a low P/B value suggests that a company may be cheap.
14. A common procedure using price-earnings ratios, price-cash flow ratios, and pricesales ratios is to calculate estimates of expected future stock prices. However, each price ratio method yields a different expected future stock price. Since each method uses different information, each makes a different prediction.