How to properly value a stock is among the most hotly disputed topics on Wall Street. There are a number of different valuation techniques, such as price-earnings multiple, price-cash flow multiple, book multiple, and discounted cash flow analysis. My personal opinion is that the discounted cash flow (DCF) analysis is the best method if only one method is to be used (combining DCF analysis with a couple valuations by multiples to affirm your estimates is better yet).
The basic idea behind the discounted cash flow analysis is that a dollar today is worth more than a dollar tomorrow. That is, a dollar today can be invested for say 7% and be worth $1.07 in one year, so a dollar today is worth $1.07 in one year. Conversely, $1.07 in one year is worth $1 today ($1.07/1.07 where the denominator is equal to one plus the return available on an investment over the period under consideration rate - in this case one year). That 7% is called a discount rate. One of the jobs of the stock analyst is to determine the appropriate discount rate for a given stock - the higher the perceived risk of the stock, the higher the discount rate. Academics like to compare the given stock's price fluctuations relative to the overall market and use this comparison to determine the risk and therefore discount rate. For example, consider a stock that does very well in economic upturns and very poorly in economic downturns, this stock would have higher risk than the overall market and therefore a higher discount rate. I don't feel that this approach is adequate when valuing a business, but have yet to come across a better method.
Once the discount rate has been established, let's say in this case it is 10%, an analyst must forecast the future earnings of a stock. For this simple example, let's assume that the analyst predicts earnings of $5 per share one year from today, $8 per share two years from today, and $10 per share three years from today. After the end of the third year, the company will be shut down and all past earnings paid out to shareholders in a special dividend (for simplicity let's assume they have no assets other than retained earnings and no debt - unrealistic, but simplifying). It is important to note that the second year's earnings must be discounted at 10% twice, once to determine their value at the end of the first year, and again to determine their value today (or present value). Therefore, the second year's earnings are worth $7.27 at the end of the first year ($8/1.1) and $6.61 today ($7.27/1.1). A similar process must repeated threefold for the third year's earnings.
Considering the above, first year of earnings would be worth $4.54 today ($5/1.1), the second year earnings would be worth $6.61 today ($8/[1.1*1.1]), and the third year's earnings would be worth $7.51 ($10/[1.1*1.1*1.1]), for a total value per share of $18.66 today.
This is a very simple valuation, but I hope it gives you a better idea of how the valuation process is carried out.
I have had a few friends who are not in finance ask me to explain to them how the stock market works. These discussions usually end up occurring over a few beers and the lack of a written record tends to leave my audience with a bunch of confused ideas. As a result, I have decided to add a series to my blog to educate the layman on just how the stock market (should) function.
The most basic question to be answered is "what is a stock?". If an investor buys a share of a company, they are buying an interest in that company which represents a claim on a proportion of the companies earnings (after payouts to debt holders and preferred shareholders - more on them later). For example, if an investor buys one share of Company X and there are 100 total shares on the market (and no debt or preferred shares), that investor essentially owns 1% of the company. Therefore, if the company earns $500 net of taxes, the shareholder has a claim to $5 of those profits ($500 X 1% = $5). Additionally, publicly owned corporation are run as a democracy and the shareholder who owns 1% of the company has 1% of the votes in this democracy.
Since it is too cumbersome to hold a shareholder vote for each business decision, the shareholders elect a Board of Directors to oversee running the company. The Board appoints a management team (CEO, CFO, COO, etc.) who they see fit to best run the company and if the shareholders are unhappy with any of them, they can vote them out.
