Ever wonder where stock prices come from? If you're like many investors, you probably don't -- you just hope they'll go higher after you invest.
Are they based on earnings? Revenues? Company assets? Cash? Well, truth be told, nobody knows.
At least nobody knows in the short term. In the long term, things are a little different. Still no certainty, but many of history's famous and most successful investors -- Ben Graham and Warren Buffett to name a few -- along with quite a few less-famous ones, would tell you that over time, a stock's value is basically tied to its share of the cash earnings of a company. And, not coincidentally, that's a large part of the philosophy behind our market-beating Hidden Gems newsletter, too.
But harken back to two words from that paragraph: over time. In the long term, I'd argue, a stock simply can't sustain value without cash earnings. But the short term is another game entirely. Stocks can and do swerve from their "intrinsic," earnings-delineated values, and that's a belief held by most these days save for a specific segment within academia -- holdouts from the decade-plus-ago heyday of "efficient markets" theory, a belief that, when taken to its extreme, suggests stock-picking is futile, as all stocks offer equal investment opportunities proportionate with their risks.
Actually, we do need some degree of efficiency to have comfort in stock-picking -- if markets were totally chaotic, we'd have little assurance of stocks gravitating toward our earnings-based intrinsic value estimates. So buying a stock is like trying to spot a road that, over its distance, clearly tracks north, but at a bend that may be east-, west-, or even south-facing.
Of course, nobody wants to be on the wrong road. So how do you know if you've taken a wrong turn and are holding a stock priced far above its sustainable, earnings-based potential value? There's no quick-yet-accurate way to estimate a stock's intrinsic value, unfortunately. But if you'll settle for quick-but-semi-accurate, you have options.
One is called a discounted cash flow (DCF) valuation, wherein you project cash earnings into the distant future. But since a dollar is worth less the further into the future it's to be received (for both opportunity cost and possibility of non-payment), those expected earnings must be discounted back, and then summed together, to arrive at a value estimation. The sketchier the company, the higher the discount rate.
Quick and dirty for starters
In this case, we're all about the quick and dirty. So in arriving at my list of five potentially overvalued stocks (bet you thought I'd forgotten), I'm using accounting earnings (net income) as a proxy for cash earnings -- were you seeking thoroughness, you'd want to make a few adjustments. I'm also using a catch-all 13% discount rate, a rate I'd use for a moderately risky company. How do I know future earnings? I don't, so I'm using analyst-projected five-year earning estimates, which are expressed as an annual rate, but to be nice, I'm pretending they'll last 10 years instead of five (earnings growth typically slows for companies as they age). After that, I'm presuming they'll grow at a 4% overall-economy growth rate -- ending with a constant growth rate is a requirement of DCF analysis. And, also for simplicity, I'm assuming no share buybacks or dilution, either.
OK, enough words. You're patient, but there are couch-potato investors reading who just want me to tell them what's overvalued and perhaps mentioning the degree to which, so they'll have their false sense of security. Unfortunately, I can only tell you, and them, what looks overvalued, and only based on this simple little model; the market clearly has other, greater, expectations than the ones I'm pricing in. And bear in mind that these companies may be perfectly fine as companies -- it's their stocks we're talking about here.
Did I screen every company out there? No. I just picked a few -- some of the more popular, and perhaps more speculative, stocks in the buzz today.
The Fool's Rex Moore threatened to block publication of this article unless I peeked at online travel company Travelzoo
But no, the winner is Computer Associates
Try this at home
So how do you package this goodness and take it home with you? A first step would be to remember that these are just estimates -- additional information would be needed in each case for something more definitive to come out. The best step -- something we'd encourage everyone to do -- would be to begin reading more about stocks, investing, and valuation. You can find plenty of information on our site and its discussion boards, as well as elsewhere on the Internet. And many of the best investors, like those mentioned earlier, have chronicled their wisdom-building experiences in books like The Intelligent Investor, Security Analysis, and One Up on Wall Street. With the knowledge you'll pick up, you'll be doing simple valuations soon enough.
But realistically, and yes, you do smell a small (but courteous) plug coming up, we know many of you don't have time for all this. Maybe it just isn't your cup of tea. But then a little voice reminds you that your retirement is coming, and sooner than you realize -- and you want to be looking forward to it with excitement, not fearing running out of money.
You have several options. You can suck it up and do this stuff anyway -- and you may well like it more than you think. You can keep in touch with a smart friend or advisor passionate about investing, find a quality mutual fund or ETF with reasonable fees, or (gulp) perhaps consider a newsletter.
DCF is one of the techniques we use in Hidden Gems to drum up winners, but we work from the other end -- finding stocks trading well below their intrinsic values. In fact, Motley Fool co-founder Tom Gardner's picks have handily beaten the benchmark S&P 500 index by 32.82 percentage points since the service began in July 2003. Like everybody else, he'd love to find a rock star like Dell
Speaking of valuation, Hidden Gems might be one of the most undervalued investments you'll ever encounter. On par with a fancy dinner for two, it's a bargain relative to the fees people pay to mutual fund managers or investment advisors, and, even better, it's completely free to try for 30 days. No catches. Just click on the link to take a peek -- it won't hurt a bit, I promise, and you'll get to see photos of Tom to boot. One last thing: You'll notice Hidden Gems focuses on small caps. Why? Because they present the most profitable investment opportunities for people like you and me, something you can read more about on the Hidden Gems site itself.
Until next time
Wherever your investing preferences may take you, I encourage you -- no, beseech you -- to acquaint yourself with the factors generally accepted by the value investment community as sustaining a stock's long-term value. Newcomers may be disappointed with the ambiguity, but it's that very ambiguity that makes profitable investing possible. Make sure to use it, but don't get lost in its haze. Simple models like the one above admittedly don't cover all the bases, and many seemingly overpriced stocks continue to rise. Do your homework before jumping aboard, though. Once the haze clears, you may find yourself sitting on a time bomb.
James Early has learned the secret to life is having low expectations, and wishes his employer felt the same. He owns none of the stocks mentioned in this article. The Motley Fool has a disclosure policy.