Introduction To Valuing Stock

I have always wanted to write an article about valuing stock.  Even though I know somewhat how to find a value, the process is very subjective.  You may have a different opinion about one of the variables from another person, and you can debate the pros and cons of each side for days.  So lets find a simple way to assess the value, and then we’ll look at an even simpler way.

For the purposes of this article, we’ll assume you are buying shares of stock for personal ownership, not as a company trying to acquire another company or something.  A share of stock is a partial ownership of a company.  The value of a share of stock is equal to whatever somebody else is willing to pay for it, period.  That would be the market value of a share of stock.  Any other value really is trying to second guess the market, assuming that the market is acting in an irrational way, which may value the stock higher or lower than it is truly worth.  The truth, though, is that if you figure a share of stock should be valued at $60 and the market value is $40, it’s worth $40.

Determining Actual Worth

Ok, so you think you can out value the market?  Well then, let’s try to find a method of doing this.  Let’s say there’s a corporation with 100 shares of stock outstanding and it has assets totalling $1000.  Is a share of stock worth $10 then?  Nope.  Asset value has no relevance, unless you are going to liquidate the company and are able to actually get $1000 for the assets after expenses.  A better method is to look at yearly earnings per share or yearly dividends per share.

Yearly earnings is the profit the company makes.  Profit is revenue minus expenses.  Revenue is the total amount of money the company takes in and expenses are all expenses of the company.  For instance, if the company purchases an item for $1 and sells it for $2, revenue is $2 and expenses is $1, making earnings of $1.  There may be other expenses involved, but let’s keep it simple.

Dividends is simply the amount of money the company chooses to pay out to their shareholders.  Notice the word chooses, because this amount may be more or less than earnings.  For instance, say the company has a regular dividend of $1 per share but only has earnings of 50 cents during this period, resulting in paying out more than earnings in dividends.  Most of the time though, dividends will be less than earnings.

Neither earnings or dividends are a perfect method to gauge value because one could say that earnings have no value to the shareholder until dividends are paid, but paying out less dividends than earnings results in a build of company assets, probably cash, which could be paid out at a later date or invested in a project which will create more profit for the company.  So growth in earnings may result by reinvesting earnings.

So how to value a share of stock based on earnings or dividends?  Let’s use dividends for this example.  Let’s say that a company pays out 5% of the market value of it’s stock as dividends.  Is this good or bad?  Well it is more than investing in a savings account at 1% and a little more than investing in a 30 year treasury bond.  So it could be good.  It really depends on how much risk is involved.

Determining Risk

If a company is stable and is expected to have similar earnings, good times or bad, into the foreseeable future, we would expect to have a yearly dividend comparable to a short-term U.S. Treasury Bond, because there is no risk involved.  Generally, though, this is impossible to say about a company because so many things could influence the performance of the company, even to the point where the company would need to reduce it’s dividend.  And the more likely it is to be impacted by adverse circumstances, the greater the risk.

Usually the greater the risk of the investment, the more of a risk premium we would want to be paid.  So a very risky company might have a 15% dividend or higher.  It is really up to the judgement of the shareholder (or analyst) what the risk is, and hence what the risk premium should be.

Valuing Companies With No Dividends

Companies with no dividend at all would represent a very high risk typically because the share would seem to be valueless.  People do pay good money for shares of stock with no dividends, though, so how do you figure a value?  You might use earnings per share to determine value, with a very high risk premium.  If the company is reasonably stable and growing rapidly, you might accept less of a risk premium.  It’s really up to your own judgement.

What to do with your value

You now have a value per share.  How did you get it?  You know that dividend / value = rate, and you’ve determined the rate you’d be willing to accept based on risk.  You should also know the dollars dividend per share.  So we can switch around the formula and get value = dividend / rate.  So lets say the rate is 10% and the dividend is $1 per year.  The value is $1/.10 or $10 per share.  If the current share price is $8, it might be a buy.

Market Pricing is Perfect Pricing

If you bought your share of stock for $8, could you turn around and sell it for $10?  Nope.  The market is willing to pay $8 so you can sell it for $8.  And why is it $8 when you think it should be $10?  Because the market, for some reason, thinks the risk is greater than you do.  Perhaps there is information you haven’t taken into consideration.  Maybe there’s turmoil in the world.  Maybe management at the company has just changed.  It could be anything, or it could be nothing.

If market pricing is perfect, as the theory goes, then why could the reason be nothing?  You have a lot of great people who think about the value of stock, then buy and sell based on their value.  Others will simply buy what they like or sell if the market’s going down, or do many other irrational things.  So the perfect market pricing theory is a little true and a little false.

If you want to believe that market pricing is perfect, that’s great.  Then the price the market is willing to pay today is the value of the share of stock.  Then you would buy a stock just to be invested, catch the share price growth or dividend growth if there is any.  And truthfully, it really could go either way.

A basket full of stocks

As the theory goes, the more different shares of stock you have, the more you have diversified the risk.  In other words, it’s more risky to own $10,000 worth of one stock than owning $10,000 evenly split between 50 stocks.  The overall market will go up and down, but mostly up over time, but an individual stock could soar or go out of business.  You really don’t know for sure.  But buying many stocks virtually eliminates the risk of a big loss because of a bad company.

Summary

Valuing stocks is a tough job for a novice investor.  It is sometimes best to buy good diversified mutual funds rather than invest in individual stocks.  But if you can have a diversified portfolio of stocks, your risks are reduced and you will pay less in fees than owning a mutual fund.  However, you really need to understand what you are doing before you jump in with both feet.  Invest with a small sum of money for a while.

This is the longest article I’ve ever written on any subject and I hope it was informative.  I tried to keep it as simple as possible.  If I got something wrong, I do apologize, I am not a stock analyst by trade.  I am just trying to provide basic information.

How do you choose what shares of stock to buy?

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