How to value stocks – an introduction to valuation concepts
Two years ago I wrote a popular blog that explained some simple share market concepts and jargon (see
here). Building on this introductory information, I thought it was timely to discuss basic share market valuation principles to help investors assess whether a stock is over or under valued.
To be clear, I’m not advocating investing in direct stocks. In fact, there is an overwhelming amount of evidence that demonstrates direct share investing (i.e. picking stocks) fails to produce above market returns over the long run. However, it is still useful to understand basic share market valuation principles.
The ‘Efficient-Market Hypothesis’
The Efficient-Market Hypothesis (EMH) was popularised by Nobel laureate, Professor Eugene Fama. The hypothesis suggests that share prices always accurately reflect all available information. The idea is that the market is made up of thousands (and in some cases, perhaps millions of people) that analyse all available information in relation to a particular company. Many of them are professional investment managers with a lot of education and experience working 40-80 hours per week. This information informs their trades i.e. at what price they are happy to buy and sell. And it is this process of “price discovery” that determines the value of a stock.
My personal view is that the EMH might be true over long periods of time. However, in the short run, it is possible (in fact, likely) that markets can be inefficient. Behavioural economics explains that sometimes investors can act irrationally, driven by overconfidence, overreaction, overexuberance, greed, fear and so on. The
“meme stock” behaviour earlier this year is a perfect example of how markets can be inefficient and stock prices can be wrong.
This is why it’s useful to understand basic valuation principals.
The value of a business is equal to the present value of its future cash flows
The value of any business is equal to the present value of its future cash flows. To calculate that, you need to forecast the business’ free cash flows and then apply a discount rate to express the value in today’s dollars. The discount rate must reflect the risk associated with the
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