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To: Chuzzlewit who wrote (9154)	8/12/1999 9:28:00 PM
From: John Malloy	Read Replies (1) \| Respond to of 21876

"I believe that there is a central flaw in your method of forecasting the future value of the stock. Specifically, the price to book ratio is a function of the price of the stock and the equity per share. The price is not a function of the ratio. The ratio is a function of the price. I believe you are confusing cause and effect." Mathematically there is no reason you can't consider the stock price to be a function of the price/book ratio and equity/share instead of the other way around. You can forecast the price/book ratio in the same way you forecast the return on equity a firm earns and the firm's growth rate. Once you forecast the growth rate of equity/share and the price/book ratio, you have implicitly forecast future stock prices. "BTW, the Gordon perpetual growth model does use cost of equity in the denominator to calculate the value of a share. It uses the difference to calculate the PV of a stream of dividends on a per share basis. In fact, this relationship is one traditional method used to determine a firms cost of equity capital." The Gordon perpetual growth model shows up in all the text books, but the limitations are so great I don't know anyone who actually uses it. One limitation is that the growth rate is assumed to stay constant forever, out to infinity. The second is that the model forces the cost of equity to be greater than the growth rate. These restrictions give ridiculous results for growth firms growing, say, 30 %/yr or more. When firms raise equity capital the firm is on one side of the transaction and the investor is on the other side. A cash inflow to one is a cash outflow to the other. That makes the cash flows identical. And that means that the same discounted cash flow model can be used to find the firm's equity cost as is used to find the investor's return and the value of the stock to the investor. A growth firm needs to make realistic forecasts of slowing growth, falling price/book ratios, and the gradual introduction of dividends when it calculates equity cost. That means the firm needs to draw the same free-hand forecast curves I do, and use the same basic model I do. John Malloy