D1/k-g is the basic formula for all future value of cash (time value of money). It could be your savings account, a CD, a bond or some value pulled off the financial statements. Become a Complete Fool
I'm not in complete agreement with some of our other posters. I don't believe in a complete Efficient Market Hypothesis. But you will notice that stocks tend to trade in relatively tight range unless there is a significant change in company financials. Short-term news tends to create short-term changes in prices; long-term changes tend to create long-term price changes.
Two things seem to drive valuation more than any other: "Market Sentiment" and "Fundamental Value". The two relate to form a price range. Google is an example of market sentiment pushing the price range to the high end. If you crunched the numbers you will find that it will take almost a decade of superior performance for Google to [be] "fairly valued". Or for fun, look at Taser's two-year chart; you'll see when the market thought better and worse of it. Its "fundamental value" can be normalized, smoothed, and hasn't changed dramatically over the two-year period.
The simplest expression of market sentiment is P/E. High P/E's are market favorites and as such people are willing to pay a "premium" to own such stellar companies. Low P/E's are in the Market's dog house and the market has to sell them at a discount to find a buyer.
Fundamental value is what the numbers tell us. We can use dividends, owner's earnings, normalized earnings, Cash Flow, Free Cash Flow and there are probably a couple other flavors. The moment you move away from reported earnings you are making educated assumptions about the adjustments.
Why would we make adjustments to reported earnings? Because earnings aren't pure cash profits that one could take to the bank; some of earnings is non-cash, some of earnings is "one time charged" or "one timed something or other". Frankly the publisher of earnings knows that Wall St. and its shareholder are watching so they play legal games with the numbers to make sure they don't miss "estimates" very often.
Fundamental valuation breaks down into two broad camps. Relative valuation and Cash flow analysis/dividend discount analysis. Relative valuation takes like companies in like industries and compares basic metrics like P/B, P/S and P/E. We create an average for the set of like companies and that defines what is richly valued and what is poorly valued.
Cash Flow analysis is an attempt to forecast the present day value of the future cash/dividends the company is expected to produce over its life. The beauty of the dividend discount method using only dividends is that it is conservative and you are only valuing real cash that will be deposited in your account (assuming the company doesn't die prematurely).
None of the methods discussed are secrets, obviously. Very smart people are applying them every day to make buy/hold/sell decisions. This creates a price range for most stocks.
How does one make money in the market then? For "value" investors the answer simple. Don't argue with the market over "hot" stocks. It doesn't matter that every time I value Google I get $125ish, the market disagrees and I'm not likely to get my price for a long time. However on the low end of things, from time to time, market sentiment undervalues a perfectly good cash generator. Market participants are in the game to make money; eventually they will notice companies that are generating consistently growing cash/dividends/earnings.
But if you really want to learn valuation techniques [Amazon link]...
he also offers wonderful help on his web site. Truly the guru of valuation methodology.
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D1/k-g is the basic formula for all future value of cash (time value of money). It could be your savings account, a CD, a bond or some value pulled off the financial statements.