risk and reward
The easy answer to the question of how much a stock is worth is the following: a stock is worth the amount of all future cash flows to you plus a reward for your time holding the investment and for the risk you are taking. The longer the time period you hold the stock and the greater the risk you take, the greater the reward you should expect. Ideally, you want cash flows to exceed your required reward for time and risk. This seems fairly simple, but unfortunately, nobody has a crystal ball to determine what the future cash flows will be.
future cash flows
Without a crystal ball, we need to use as much public information available to us to estimate the future cash flows of an investment. Because we do not have all necessary information, valuation is as much an art as it is a science. This is why multiple analysts using similar information can have widely varying opinions of value. Yahoo, for example, has had five major Wall Street analysts change their opinion of the company in February 2008, with one analyst upgrading Yahoo and four downgrading it. Its rankings vary from strong buy to hold to underperform since each analyst uses different pieces of information and different approaches to value the company.
One method used to value a stock is called the Dividend Discount Model. This model estimates the value of all the dividends the stock will pay in the future; since as a stockholder this is normally the only way you will see cash until you sell the investment. To calculate the value using this method, each future dividend is discounted to the present value. Discounting is a way of saying that a dollar today is worth more than a dollar a year from now. For example, the value of one dollar that you will receive a year from today is worth only about $0.91 today if you discount at 10%. This calculation is done for all future dividends, with the discount rate being the return that the investor requires for the risk assumed.
A similar model can be used to value the company by discounting the cash flows to the company before investors and debtors are paid. These cash flows are discounted at the weighted average of the company’s cost of debt (the rate it pays on debt) and the cost of equity (the same rate used for the Dividend Discount Model).
relative value
A more common approach to stock price valuation is the Relative Value approach. Most investors use this method to determine the price they feel is appropriate for an investment. Relative Value consists of looking at a number of financial variables and comparing them to the company’s historical stats, the industry average, the market average, or competitors. When the comparison is favorable for some or all of the variables, the stock is considered a bargain.
A frequently used variable for the relative value approach is the P/E (price/earnings) ratio. This ratio gives the price of the share compared to the earnings per share for the company. This can be done for the earnings from the past year, also called the TTM (trailing twelve months) P/E, or it can be done for the estimated earnings for the next year, also called the Forward P/E. Other common variables used to value the shares of a company’s stock are price/cash flow, book value, growth rates, return on equity, return on assets, gross margin, the dividend yield, the current ratio (current assets/current liabilities), and just about any other piece of information that may indicate the financial status of a company.
putting it all together
There is not one approach that is the “correct” way to value a stock. This is where the art form comes into stock price valuation. A complete investment analysis will use a combination of the above three methods as well as a number of other factors that determine if a stock is trading above or below it’s actual value. Other factors could be the management’s capabilities, demographic and economic changes that could create growth in the company’s sales, the value of the company’s assets, products in development, legal issues, and even technical analysis. Once adequate analysis of the publicly available information is completed, it should be all put together to determine your course of action for the stock, whether it is to buy, sell, or hold.
Steven F. Schreiber holds a BA in Economics and International Studies from the University of Richmond, as well as an MBA with a specialization in Finance from the University of Miami. He is a Chartered Financial Analyst, a member of the CFA Society of Orlando, and a member of the CFA Institute.