In investment of any kind, you should be able to place a value on any form of asset. Putting the right dollar value on any investment is critical to investing success because this information will make all the difference between a profit and a loss besides providing you with information about whether you should be buying or selling. This necessarily means that you should look beyond the present to evaluate the future prospects of the company in which you are considering investing. You should also know the difference between price and value. As the legendary investor Warren Buffett once famously said, price is what you pay but value is what you get.
There is no doubt that price is an important consideration but a single-minded focus on price alone is not enough if you want to be a successful long-term investor in stocks. Discovering the right price means that you need to look at all the factors that determine the true worth of an investment and realizing that there is a world of difference between cheap and the right price. If you make up your mind on price alone, never forget that cheap stocks are cheap because of negative factors which would put a question mark over your investment.
No matter what valuation techniques you use to determine the value of a potential investment, it takes time, effort and a grasp of the fundamentals. People may buy or sell stocks for all kinds of reasons but, if you want to be successful, these decisions should be based on a process of logical and objective analysis. You may also want to keep in mind that no two companies or businesses are completely identical and not two valuations may be exactly the same because of the assumptions you need to make about the future. Valuation is not an exact science because of these assumptions and it is not simply a question of crunching a few numbers. In fact, the ability to make reasoned judgments based on these numbers is far more important than the numbers themselves.
There are three major techniques that you can adopt in valuing a particular company’s stock. Asset-based approaches [which are also referred to as asset cost based approaches] concern themselves with establishing realistic values for the assets and deducting the liabilities to arrive at an accurate net worth. Naturally, this is much easier in the case of tangible assets like plant and machinery or property than in the case of intangible assets. The second technique concerns itself with using comparisons to comparable businesses with the use of financial ratios. This will enable you to determine whether your proposed investment is overvalued or undervalued in relation to its competitors. The third technique is the income approach where your predictions for items such as future income growth and cash flow generation or discounted back to arrive at the present value. The success of this method of valuation and its accuracy depends critically on the assumptions that you make about discount rates and growth rates. Because of the relatively long time frame, even a minor error at the start of your calculation can have a disproportionately large effect on the ultimate valuation.