One of the biggest reasons why many people lose money in the stock market - they don’t know how much a stock is worth.
Imagine you went to a supermarket to buy a loaf of bread but you see that it costs $20.
Is this a fair price to pay? Would you buy it?
Hell no!
The funny thing is - this is exactly what people do in the stock market.
The higher the stock price runs, the more people are willing to buy.
They are happy to overpay for stocks, viewing them as nothing but numbers on a screen
This is akin to saying “I prefer to buy a loaf of bread at $20 vs $5”.
Sounds ridiculous, but while this is rarely seen in the real world, such behaviour is common in the stock market.
This comes when people have no clue how much the stock is worth.
The Tricky Part of Valuation
Just like how there isn’t only one way to skin a cat, there’re many ways to value a stock.
Individual personal preferences are at play here.
Everyone of us place a different value on a certain item.
Designer bags might be worth thousands to some, at the same time, it might be worthless to others.
This subjectivity is also present in the stock market.
When we do a discounted cash flow analysis, this comes up in the growth assumptions we place in a stock.
At different growth rates, the intrinsic value of a stock can be wildly different.
It’s why people have so many different valuations for the same stock, even when using the same numbers from the company’s financials.
How to value a stock?
Valuing a stock can be as simple, or as complicated as we make it out to be.
Cash
Cash is the lifeblood of a business (and of individual investors).
2 cash related metrics we can use:
Operating cash flow
Cash and short term investments
Debt
While there are both good and bad debt, the ideal business to own is one with little to no debt.
A company with little to no debt can withstand economic downturns, as opposed to one with a huge debt pile.
Growth Rates
This is where the subjectivity comes in.
Trying to estimate a company’s growth rate is no easy feat.
The further out into time we go, the more unpredictable it becomes.
Some websites we can use to help us:
1. Finviz
2. Morningstar
Conclusion
DCF works for most companies, with a few exceptions.
For one, DCF analysis doesn’t work on on loss-making companies, simply because there’s no cash flow as they’re not making money.
It’s why I don’t buy into loss-making companies - it’s not within my circle of competence.
I’m perfectly fine with missing out on gains, if it means that my downside is protected.
I hope you enjoyed reading this piece as much as I did writing it.
If you’d like to connect, I am spending a lot more time on Twitter/X these days. Follow me over there for more investing and personal finance content