How to Value A Stock, Simplified

You could write a book about stock market valuation. In fact, many have! Here, we start with the basics. You’re not going to learn the trade secrets here, but you’ll avoid the common mistakes.

MORE THAN A TRADING INSTRUMENT

A stock is not just a trading instrument; it represents a share of ownership in a company. It’s easy to get caught up in the hype and forget that a stock’s long-term performance is driven by the underlying company’s success. For example, Apple stock can’t keep going up forever without the company continuing to innovate and grow. Otherwise, it’s just hype – there’s nothing to support the share price, and it will eventually come back down.

Although a stock’s short-term price movement can seem unpredictable, its long-term value is determined by the company’s performance.

DEFINE EXPENSIVE…

When someone labels a stock ‘expensive’, it’s important to know what they mean. It doesn’t just mean that the stock price is high, e.g., £200/share vs £5/share. A stock can only be labelled expensive if its price is high relative to its earnings.

The value of a stock is the value of all future cash flows received from owning the company, adjusted back into today’s money. This adjustment is required because the value of a dollar today is greater than the value of a dollar in thirty years – due to inflation and the time value of money. We also need to account for the risk that the company slows down or goes bust.

To determine a stock’s value, as yourself these three questions:

1) What are the company’s current earnings?

2) What will be the company’s earnings in the future?

3) Based on the company’s prospects and risks, how high a multiple of today’s earnings are you willing to pay?

The first question can be answered by examining the company’s financial statements. However, beware that companies may try to dress up their earnings, for example by labelling regular expenses as one-offs, and housing certain items off-balance sheet. The takeaway is that today’s earnings today require adjustments to make them representative.

The second question is more complex, and depends on several factors, including:

• What is the company’s competitive advantage?

• How stable is its industry?

• How strong and stable are its margins?

• How competent is management?

• Is the company leveraged?

These questions are part quantitative, part qualitative. You need to comb through numbers but also think outside the box. You also need to be aware that it’s hard to predict the future, and that – no matter how good you are – you will get some of this analysis wrong.

The third question depends on the profile of the company. Generally speaking, a price to earnings ratio of 15x is about normal. That means that if the earnings per share are $1, a fair price would be $15. Through a different lens, if you pay $15, you receive $1 of earnings (a 6.7% earnings yield, as 1/15 = 6.7%).

SO – IS IT BAD TO PAY MORE THAN 15x EARNINGS?

A company’s fair value is determined relative to its earnings. If the earnings are strong and stable, with competent management, low leverage and a leading position in a growing industry, it could make sense for the company to trade at more than 15x earnings. And for a poorer company, it makes sense to pay less than 15x. If there’s a higher risk of the company’s earnings declining in the future, we might only feel comfortable paying 7x or 8x earnings instead.

It can be tempting to buy shares in a company because they are cheap, relative to earnings. But beware the value trap. The company may be cheap for a reason, and they may be a high likelihood that the company goes bust.

Similarly, it can be tempting to buy shares in a great business, like Nike, Microsoft, or L’Oréal. But if you’re paying far in excess of 15x earnings (say 30x), there is the risk that something happens to this business which disrupts it, and suddenly, rather than paying 30x earnings, the stock is valued at 15x earnings. This is the quality trap – you overpay for something which is not as good as it seems. When this becomes evident, the share price falls sharply.

There’s no one-size-fits-all approach. To better understand a fair value, we need to dive deep into the numbers and the business’ prospects – a part quantitative, part qualitative analysis. What’s clear is that a good company does not necessarily make a good investment, if it’s at the wrong price.

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The purpose of this article is to provide a straightforward understanding of stock valuation, so you can make more informed investment decisions and avoid common mistakes. Here are the key points to keep in mind:

• Don’t base your decision to invest in a company solely on its share price trend. Instead, focus on whether the company is reasonably valued based on its earnings.

• A great company at the wrong price can be a poor investment. An average company at a great price can be a good investment.

• Forget about short-term moves in the share price. It’s the long-run that matters.

• Keep in mind that a stock represents a slice of ownership in a company

• Most retail investors struggle to beat the professionals, and most professionals struggle to generate sustainably strong performance. So if you’re choosing your own stocks, be honest with why you think you can do well!

• You don’t have to pick stocks. You can invest in a fund and have the professionals do it for you. This can be an active fund, where a professional investor picks their best-value companies for you, or an ETF / index fund, where you simply buy all companies in an index. For example, an ETF or index fund on the S&P 500 index would buy the 500 largest publicly-traded US companies.

While there is much more to explore, these tips can be helpful in avoiding some common mistakes.