TANA-NOMICS: How to Price Stocks (the right way)
Every time I discuss investing some people (maybe like two) think the discussion was too broad and ask for a more detailed follow up. I am certainly able to provide all the gory details so that by the time we're done you'd have a finance degree from TU (TANA's Log University). It would probably be more useful than anything you get from GATE.
People seem to think investing is as simple as mixing cement or tiling a floor, both of which I cannot do. I mean how do you make sure the thinset is not too thin or the mortar not too hard? I mean I didn’t even know it takes 21 days for concrete to reach full strength.
In reality investing is actually the end result of a number of complex activities or at least it should be. There's a lot of analysis that should take place prior to deciding that XYZ stock is a "buy" or that LMN bonds provides a good return for the risk. If you’re putting money into investments willy-nilly based on a feeling, then you my friend are gambling not investing.
The main principle behind investing is buying an asset at one price and selling it at a higher price at some point in the future. Sounds simple right? Wrong! Well, actually it depends on the asset. Real estate investing for example is a little more straightforward than investing in other assets. You buy a property, improve it and try to sell it for a higher price or use it for rental income.
However, even with real estate you need to know what the house is worth or the price it could potentially be sold for. In investing, what something is “worth” is called the ‘intrinsic value’ and the way it is calculated varies by asset. One could argue that what something is worth is based on what other people are willing to pay for it, but I’m not here to argue philosophy with you, I’m not Matthew McConaughey in them perfume commercials.
As I've said a number of times in the past, the value of any asset is the total of the value of the future cash flows from that investment brought back to today's value using an interest rate that reflects the risk of that investment. Sounds like ‘gobbly-gook’ ent. You’ll get it hopefully by the end of this long long long post.
Time Value of Money (TVM) is the financial sorcery that allows us to do this. TVM basically states that the value of $1 today is worth more than $1 tomorrow. Yup, we all should know that. The reason this is the case is because of interest. The main concept in TVM that helps us value securities is the present value of cash flows (PVCF). Basically this helps us answer the question what is the value today of a dollar in a future period?
Let’s use an example, to make things easy, let's say prevailing interest rate in the market is 3%. What if I told you I could give you either $500,000 per year for 20 years (totalling $10M) or $5.5M today which would you choose? Seems like a no-brainer right, $10M is more than $5.5M. Well at 3% those two values are actually the same. What manner of witchcraft is this??
I know right? HOW? Well because if you took $5.5M today and invested it at 3% compounded annually, you would end up with $10M in 20 years (don't come at me talking about rounding error). Better yet if you could earn more than the 3% than yuh ahead of the game, “yuh GT”. Now there's a pretty useful formula we use to help us calculate that but you ain’t need to study that.
How do we use this concept to value securities? Well the short-ish version is we project (educated guess) forward for a certain period, the amount of money a company may earn each year or pay in dividends depending on the method we choose. Then we divide those cash flows by the special formula, a process known as ‘discounting’ and we bring back each future year’s cash flow to today's value. Then we work financial ‘obeah’ and estimate how much the company could earn from the end of that initial period to perpetuity (forever…till it dead). Now we add all that up and the total is the value of the business. We then divide that figure by the number of shares in the market and that gives you the stock price the company should be trading at.
If the stock is actually trading in the market at a lower price then it's undervalued and if it is trading at a higher price it is overvalued. Now remember the price we calculated is based on our assumptions and may or may not be accurate. Also there may be very valid reasons why it is trading at that price that has nothing to do with valuation calculations.
The actual process is far more complex and I've left out a few steps but you get the picture. There are also a few other methods of ‘guesstimating’ the value of an asset but I think I’ve lost most of you in the first two paragraphs so I’ll end it here.
You see why you should hire a professional if you don’t know what you’re doing?? Now go hit the pharmacy for some Motrin for the headache I just gave you.
TANA