For the majority of people, it's not worth their time to find a stock, estimate the value, compare it to the market, search for another stock, estimate its value and compare it to the first stock and repeat that process.
The average, everyday employee is better off leaving specific investment decisions to the professional portfolio managers. However, there is a way to make sure you always perform the same as the market — learn how it works.
After finding a potential stock, the question is how to place a value on that particular stock. Before discussing how to value a share, we should first define what a share of stock actually is.
A stock, specifically common stock, is a piece of paper representing a certain percentage of ownership of a corporation. Ownership includes all assets of the company, along with liabilities. Simply put: assets bring in money, liabilities take money away. The assets can range from cash-on-hand to the intangible value of a brand or logo. Liabilities include salaries of employees, operating costs and debt.
Valuing a stock would be very simple if it only represented current value of assets and liabilities. What makes stock evaluation so complicated (and fun!) is estimating how much the company can earn from its assets while managing its liabilities.
People don't buy stocks for the assets on books; they buy them because of the money the company should, could and might potentially make in the future. All an investor should care about is the cash a company can produce. If a company can't produce cash (or do so in the foreseeable future), it is worthless and will eventually go bankrupt — saving government intervention.
Why is it so hard to find companies that produce cash or create value?
It's not particularly hard, but past performance is not always indicative of future performance. Adding to that, there are different measures of evaluating the "success" of a company. Finance, accounting and economics each have their own way of measuring success. I won't go into the details, but the important thing to know is that no one measure is completely correct or shows the entire picture. For instance, a company can show extraordinary "accounting profits," but their free cash flow (finance's relative measure of success) might tell a different story. Furthermore, the economic value added might tell another story.
Enron is an example of a company that had incredible accounting profits, yet fundamentally the company was a mess. If investors had looked at more than just the earnings per share, the charade wouldn't have lasted nearly as long.
This is all important because the goal of stock evaluation is finding the intrinsic value of the company. This number is almost always different than the market value. The market price of a stock trades extremely erratically. Macroeconomic news such as job numbers will move the entire stock market — creating and destroying billions of dollars in the process. In reality, most news that moves stock prices has little impact on the intrinsic value of the stock. In the short run, stock prices move in a random walk. In the long run, stocks will approach their intrinsic value.
How then can we determine the intrinsic value? There are many approaches, but most are derived from the basic assumption that a company is worth the net present value of the sum of all future cash flows.
What does all that mean? Basically, you figure out all the money the company will make from now until infinity. Once you get that number, you figure out what you'd be willing to pay for it today. The "present value" of "all the money the company will ever make" is actually the estimated intrinsic value of the stock or your estimated stock price.
Now, understandably, there are a lot of disagreements on everything I just said. Different estimates on how much money the company will make from now until forever, different discount rates for calculating the present value and even completely different approaches on evaluating a stock. The point is that stock evaluation is a very complicated process. Few are very successful at it; even the best managers don't beat the market every year.
But, if you can't beat them, join them. Investing in exchange traded funds (ETFs) allows you to mimic the market. This is a great way to gain most of the benefits of investing, without all the costs. The instant diversification of an ETF is the closest to a free lunch you'll ever get, so take advantage of it!
Write to Derek at dawilson2@bsu.edu.
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