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:

Verify the variance
Most of the time, the market does a pretty good job of pricing a stock. In this particular case, only Aetna and General Mills look to be more than 30% out of line with my DCF estimate.

In Aetna'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 Aetna may be at risk of losing a large chunk of their businesses.

On the flip side, cereal giant General Mills looks to be significantly overvalued, at least at first glance. Digging in deeper, though, the entire difference between my estimate and the market's can be explained by projected growth rate. If I plug the market's estimated growth rate (8.1%) into my valuation model, the apparent overvaluation disappears. That signals that, to be successful, an investment in General Mills is dependent on the company's growth accelerating a bit from its recently weaker levels.

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 Aetna'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 48.2% gap bonus as it recovers. But you can do even better.

Take the case of consulting giant Accenture (NYSE:ACN). Motley Fool Inside Value advisor Philip Durell recommended it in 2005. Temporarily tightening margins amidst heavy competition scared away short-term-minded investors. Those shares have returned a stunning 71% since that pick. That easily outpaced the broader market. While Accenture the company has performed very well, much of our outsized return came from the company's rebound to fair value.

Find the next Accenture
To truly crush the market, you need to focus on finding fire-sale opportunities. That's our tack at Inside Value. 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 run your own calculations on stocks you uncover on your own using our time-tested value investing principles.

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 of any company mentioned in this article. Accenture is an Inside Value pick. eBay is a Stock Advisor recommendation. UPS is an Income Investor selection. The Fool has a disclosure policy.