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:

Verify the variance
Most of the time, the market does a pretty good job of pricing a stock. In this particular case, only Humana and Citrix Systems seem more than 25% out of line with my DCF estimate.

In Humana's case, the discount seems to be due at least in part to the very political nature of the health insurance business. With several prominent presidential candidates espousing plans for government-run health care, private insurers like Humana may be at risk of losing a large chunk of their businesses.

On the flip side, Citrix looks to be a bit overvalued, at least at first glance. Digging in deeper, though, and much of that premium seems to be due to high expectations and new deals enabled by its recent XenSource acquisition. Whether or not that premium is justified depends in large part on both how well the acquisition is integrated and how much net new business it really does generate.

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 Humana's case, if the market decides that America won't accept a government-run health system, no matter who wins the White House, you'll earn that 44% gap bonus as it recovers. But you can do even better.

Take the case of Discovery Holding (NASDAQ:DISCA), a holding company behind such great cable networks as The Discovery Channel, TLC, and Animal Planet. It was originally selected for Motley Fool Inside Value in September 2005. As the product of a complicated spinoff with an unclear structure, there was a significant complexity discount priced into its shares at the time. Yet as events unfolded and the market became more comfortable with the company, its shares skyrocketed. Discovery eventually trounced the market by nearly 56 percentage points before Inside Value closed its successful position.

Find the next Discovery
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 for subscribers, to help you run your own calculations on stocks you've uncovered.

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 did not own shares of any company mentioned in this article. Kraft is an Income Investor recommendation. Lab Corp. is a Stock Advisor pick. The Fool has a disclosure policy.