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 if there is, 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, perhaps believing that the stock is headed downward.

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:

Company

Trailing
12-Month
Earnings*

5-Year Projected
Growth Rate

Value*

Market Cap*

Percent Over (Under) Valued

United Technologies

$3.83

11.72%

$84.25

$79.66

(5.45%)

Praxair (NYSE:PX)

$1.07

13.20%

$25.59

$26.73

4.45%

Moody's (NYSE:MCO)

$0.87

13.80%

$21.60

$13.18

(38.97%)

Kellogg (NYSE:K)

$1.09

7.22%

$18.57

$21.76

17.20%

McDonald's (NYSE:MCD)

$1.65

8.98%

$31.07

$67.95

118.73%

Kroger (NYSE:KR)

$1.20

10.77%

$25.01

$20.31

(18.80%)

*From continuing operations. In billions.

Verify the variance
Most of the time, the market does a pretty good job of pricing a stock. In this particular case, only McDonald's and Moody's seem more than 30% out of line with my DCF estimate.

In Moody's case, the discount seems to stem from the credit rating agency that composes one of the company's business lines. That business is currently in a lot of hot water for the way it rated subprime mortgages. Parts of the international financial system are apparently falling apart because of bad investments in American subprime mortgages. As a result, investors fear that the ratings agencies may become either more regulated or less relevant, based on the way they acted in helping to fuel the fire that led to the crash.

On the flip side, restaurant giant McDonald's looks significantly overvalued, at least at first glance. Digging in deeper, though, reveals a great explanation for the entire difference between my estimate and the market's. McDonald's recently took a one-time divestiture charge for its Latin American and Caribbean businesses. If I back out that charge from my valuation model, the apparent overvaluation disappears.

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

In Moody's case, the subprime crisis will most likely subside eventually, and the market will decide that the services Moody's provides are still valuable. While it may take a few years to get back to some sense of normal, the 39% gap bonus you'd get for waiting it out as a shareholder may make it worthwhile. But you can do even better.

Take the case of pharmaceutical management services company Omnicare (NYSE: OCR  ) . Motley Fool Inside Value advisor Philip Durell originally picked it in October 2004. Potential problems with government reimbursements, combined with an expensive pending acquisition, scared away short-term-minded investors. Yet as events unfolded, turning out better than the worst the market feared, those shares doubled for subscribers. In fact, they shot so far past fair value that Philip suggested Omnicare be sold. That proved to be an excellent call, as another round of bad news later knocked its shares down cheaply enough to be re-recommended.

Find the next Omnicare
To truly crush the market, you need to focus on finding fire-sale opportunities. That's our tack at Inside Value. In addition to our own value picks, we also offer a DCF calculator in the service to help you run your own calculations on stocks you've uncovered on your own. Whether you choose to follow our lead or pave your own way based on time-tested value investing principles, Inside Value is there to help.

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 June 20, 2007. It has been updated.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Omnicare and his wife owned shares of Kroger. Omnicare is an Inside Value pick. Moody's is a Stock Advisor pick. The Fool has a disclosure policy.


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