How to select a stock- Value and Price of a stock

While many of you are aware that by owning a stock you own a company partially, I am not sure if everybody knows how a stock is valued or how its price is determined. For most of us, it is a number that keeps moving up and down based on the whims and fancies of some unknown factors. Most retail investors invest in a stock not on the basis of their research, but on the basis of tips and market rumors. Which is what makes investing in stocks a thrilling but self-defeating activity for most of them.

I think it’s important that we learn how a stock is valued and priced. This should give us an insight into how to select a promising stock later.

So, what is the value of a stock? Plainly put, it is the cumulative present value of the money the company makes at present and in future, divided by the number of total shares with various shareholders. How do you calculate it? Again putting very simplistically, you need to know the amount of cash the company is currently generating and will be generating in future. Calculate the present value of all this cash and divide it by the number of shares (I will not be getting into detailed calculations, as it’s not required. If you are more interested in finding out actual calculation, you can google ‘calculate intrinsic stock value’.) And you got the intrinsic value of a stock. Another method would be looking at the possible dividend stream of the company (current and future) and calculating its present value. Does this give you the actual price of a stock? No. I know you are disappointed with this answer and are wondering why on earth did I explain all this if the answer was going to be a ‘No’.

Let me try to explain.

When you calculate the value of a stock using any of the two methods given above, you have found out ‘intrinsic’ or ‘fair’ value of a stock. Unfortunately, calculating this value requires you to assume quite a few things including possible growth rate of the earnings as well as average discount rate (the rate of return for a risk free investment like government bonds). These assumptions vary based on each individual’s perception of the future. Therefore, agreeing on one particular value of intrinsic or fair value of a stock itself is a difficult task.

There are some other factors too. You would have seen stock prices moving by more than 10 to 20% in one single trading session for a few stocks. Does that mean that the value of a stock has changed in a single session? No. But the perceived value of the stock has changed. And all of us may have different perceived values for the same stock. Which is what matters as none of us know the actual intrinsic value of a stock. All of us can make guesses. Some of us make intelligent guesses. Some of us make foolish guesses. The difference in perceived values of a stock in the eyes of different people keeps a stock price moving. Factors like supply and demand of a stock, economic conditions, market sentiments, liquidity in the market, etc apart from the intrinsic value play a major role in determining the price of a stock at any point in time. You would have seen many stocks tanking by more than 30%-50% in the recent economic downturn. This is because now the perception about the future of these stocks has changed in the eyes of the investors.

All this is fine. But how can we ensure that we make money in the stock market. The answer is simple- by making intelligent guesses rather than foolish ones. How do we do that- that will be the subject of my next post. Till then, think about what I have written in this post.