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 making the trade with you. If you're buying, you think the stock is going up. The other side, of course, is selling because you think the stock is headed down.

Do you care what they think?
Expand these transactions over a large 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 scary to realize, especially if you have your life savings invested in the market. But in fact, it's 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. Of course, that's impossible to know exactly, but 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 companies:

Verify the variance
Most of the time, the market does a good job of pricing a stock. In this particular case, only Johnson Controls and Goldcorp seem more than 30% out of line with my very rough DCF estimate.

In Johnson Control's case, the discount seems to stem from the company's status as a major supplier to the automobile industry. With the economy at risk and virtually all the American automakers struggling, the market is showing its concerns about the future of that business in this company's stock price. In other words, the estimated 16% growth rate here should probably be cut back.

On the flip side, Goldcorp looks overvalued. Much of its premium seems to come from the fact that gold is on a tear as inflation kicks up and the dollar plummets against other major currencies. Whether or not that premium is justified depends largely on whether those trends continue. After all, your valuation is only as good as its inputs, so when something looks out of whack, it's worth revisiting the assumptions that caused that to be the case.

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.

Take the case of credit card giant MasterCard, originally selected for Motley Fool Inside Value in June, 2006. Changes to bankruptcy laws, antitrust concerns, and past legal settlements had kept the company from being properly valued by the market. That gave our subscribers the chance to pick up shares at a tremendous discount. Its shares more than tripled while it was an active selection. And while MasterCard as a company performed very well during that window, much of our outsized return came from the company's rebound to fair value.

Find the next MasterCard
Unfortunately, thanks to that tremendous surge, MasterCard's no longer the bargain stock it once was. The market, however, always offers some fire sale opportunities, somewhere. To truly crush the market, you need to focus on finding those opportunities, wherever they are.

That's our tack at Inside Value. In addition to our own value picks, we also offer a DCF calculator for subscribers so you can run your own calculations on stocks you've uncovered.

You can kick the tires on the calculator and take a look at all our research and recommendations by joining the service free for 30 days. There's no obligation to subscribe. Click for more information.

This article was originally published June 20, 2007. It has been updated.

At the time of this publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Electric. Diageo is an Income Investor recommendation. The Fool has a disclosure policy.