How to Value Stocks
Defining the True Stock Value
The True Stock Value of a business is the present value of the net assets --known as assets minus liabilities-- a business is expected to generate over its life that will eventually be turned into cash for shareholders.
The net assets a business has generated from past transactions is called its Value From Past Results which is defined as the per share value of assets excluding intangible assets --excluded since the accounting values of those assets do not accurately reflect their expected eventual cash value to the shareholders-- minus liabilities as shown on the business' latest annual balance sheet.
The net assets a business is expected to generate from future transactions is called its Value From Expected Future Results which is defined as the per share present value of the expected assets minus liabilities to be generated from future transactions also known as the discounted value of future earnings.
The True Stock Value of a business is the sum of its Value From Past Results and Value From Expected Future Results.
How to Estimate Value From Future Results
An investor needs to roughly project the future earnings of a business to determine its Value From Expected Future Results. The two factors that affect earnings over the long-term are the level of differentiation from competitors and level of demand. The level of differentiation from competitors is assessed by determining the competition's ability to develop a brand, economies of scale, and technological advantages to compete with the business. The level of demand is assessed by determining the expansion potential into new markets and the changes in reoccurring demand. When an investor has an informed expectation for the changes in differentiation from competitors and the demand; the investor can roughly project the future earnings over the long-term by starting with the past earnings and making adjustments to the future earnings to reflect the expected changes in these factors.
How to Use the True Stock Value
The True Stock Value shouldn't be interpreted as a precise gauge of value but rather as a general estimation of value. The difference between the current stock price and the True Stock Value is assessed to determine if the stock is overvalued or undervalued. A stock trading within 20% of its True Stock Value is considered slightly overvalued or slightly undervalued; a stock trading within 20% to 40% is considered moderately overvalued or moderately undervalued; and a stock trading further than 40% from its True Stock Value is considered highly overvalued or highly undervalued. The further the True Stock Value is from the current stock price, the better the expected return for either buying long or selling short the stock.
The True Stock Value is determined through logic and reason. Irrational fear and hope or the mindless imitation of others play no part in this investment methodology. By following the True Stock Value approach, you will gain confidence in your investment decisions and improve your investment performance.
As a word of caution, Warren Buffett once said in his annual letters, "Indeed, if you aren't certain that you understand and can value your business far better than Mr. Market you don't belong in the game. As they say in poker, 'If you've been in the game 30 minutes and you don't know who the patsy is, you're the patsy'."