What's This Stock Really Worth?

Are you right 100% of the time?

If so, you'd better hope that there's no one out there just like you -- and that you never trade a stock with that person. Because if you do, one of you has to be wrong.

Whenever you trade a stock, you're disagreeing with the person you're trading with. If you're buying, you think the stock is going up. The other side, of course, is selling. The seller thinks the stock is headed down.

Do you care what they think?
Expand these transactions over a larger scale, and you can see why the law of supply and demand more or less rules the trading floor. Too much supply? The price goes down. Too much demand? The price goes up.

And while each trade typically includes only an extremely tiny sliver of a company's total number of outstanding shares, the most recent trade directly affects the value of every share. In essence, a small sampling of opinions drives stock prices on a day-to-day basis.

That can be a scary realization if you have your life savings invested in the market. But it's actually a huge opportunity for you to make more money in the long run.

Dig up the facts
Even though opinions drive daily stock moves, facts drive long-term valuations. When there's a disconnect between market opinion and financial fact, you can profit handsomely.

To do so, you need to get a handle on the financial facts that best indicate a company's real worth. While that's impossible to know exactly, you can make a pretty good educated guess based on a combination of company projections, analyst estimates, and proven track records.

Once you collect the data you need, you can run it through a discounted cash flow (DCF) calculation to estimate the value of a company's stock. Here's a rough-cut analysis for a handful of fairly well-known firms (using my own projected growth rates):

Verify the variance
Most of the time, the market does a pretty good job of pricing a stock. In this particular case, only Macy's and Adobe look to be more than 20% out of line with my DCF estimate.

In Macy's case, the discount seems to be due in part to the end of leveraged buyout speculation and in part due to the fickle nature of retail. After all, leverage cuts both ways. With over $9 billion in long-term debt, that leverage could intensify the pain that Macy's would feel in an economic slowdown.

On the flip side, technology leader Adobe looks to be significantly overvalued, at least at first glance. Its pristinely clean balance sheet explains part of the premium, and the fact that the market is estimating a higher growth rate than I am helps explain some of the rest. Even accounting for those items, though, Adobe's valuation still appears stretched.

So what?
If you pay fair value for a stock, you should end up earning the company's growth rate, plus dividends over time. That's OK, but it won't help you beat the market by any significant margin.

When you pay less than fair value, however, you'll not only get a return alongside the growth rate, but you'll also profit significantly when the stock rebounds to fair value.

In Macy's case, for instance, if the market decides it's been too negative in its risk assessment, you'll earn that 33.9% gap bonus as it recovers. But you can do even better.

Take the case of electronic accounting and tax preparation giant Intuit (NASDAQ:INTU), which advisor Philip Durell recommended in our Motley Fool Inside Value service in 2005. Concerns about competition, rumblings that the IRS might require free e-filing for all taxpayers, and excessive stock options had kept the company from being properly valued. That gave our subscribers the chance to pick up shares at a tremendous discount. Its shares gained 95% in the year-and-a-half the company was an active recommendation (Philip issued a "sell" recommendation in October 2006). That easily outpaced the broader market. While Intuit the company performed very well while it was a recommendation, much of our outsized return came from the company's rebound to fair value.

Find the next Intuit
To truly crush the market, you need to focus on finding fire-sale opportunities. That's our tack at Inside Value, and our picks have stayed on top of the market since our 2004 inception. We also offer a DCF calculator in the service to help you find discounted stocks on your own.

You can kick the tires on the calculator and take a look at all of our research and recommendations by joining the service free for 30 days. There's no obligation to subscribe. Click here for more information.

This article was originally published on June 20, 2007. It has been updated.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta did not own shares in any company mentioned in this article. The Fool has a disclosure policy.