How you can value stocks consistently
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
There is no doubt that stock valuation is important in stock picking so that you can choose the stocks that are likely to show the most appreciation. However there is little or no agreement on the best way to value stocks consistently and logically and this leads to the conclusion that there is no one perfect or best way and beauty is in the eye of the beholder. Many investors rely on what we might call comparison techniques where multiples are compared between different companies that are in the same or similar businesses. Theoretically, this can help you to pick stocks that are overvalued or undervalued in comparison to their competitors.
Many investors are not entirely comfortable with comparison techniques and would prefer to use methods that use important fundamentals to establish the intrinsic value rather than merely how the company trades with respect to its competition. Because of the spate of accounting scandals in the recent past, investors are also looking for methods that are not influenced by accounting methods or subjective factors.
The problem with using measures like earnings-per-share [EPS] is that earnings is the figure most commonly manipulated by company management to make the company look good. This can be achieved by incorporating one-off items, non standard accounting policies or other means to inflate earnings. If you look at the situation objectively, it is clear to see that one of the few items on the financial statements that is not subject to manipulation is cash because cash is a hard number and not a perception. By this logic, it is possible to estimate with reasonable accuracy how much cash the company is going to generate after meeting its obligations and base the valuation on the present value of this future cash flow.
As an example, if you want to chose between $1000 offered to you today and $1000 offered to you three years from now, it does not take any great investment knowledge to take the money offered today because you can earn interest on it right away. However if you were to be asked how much you are willing to pay today for $1000 to be received 5 years from now, this is a much trickier question. In other words, how much would you be prepared to pay for future cash flows?
To answer this question, you will need to include in your calculation the expected inflation [because this will erode the value of your investment] as well as a reasonable rate of return which is adjusted for your risk. If you were to run the members, you would find that the present value of $1000 to be received in five years time is around $747 assuming a rate of return of 6% annually. If you apply this analogy to a company’s stock, the cash flow that you would use for your calculation would be the free cash flow that is generated in excess of what is required to meet obligations. This should make it clear that provided you use realistic rate of return, discounted cash flows are an effective and reliable method of calculation.
Tags: DCF, discounted cash flow, Investing, Stock Market, stock market advice, stock market for beginners, Stock Market Investing, stock valuation