The question that often comes to mind is do market prices of shares reflect their true value? It gets further confusing when someone writes about “value investing”? Does it mean that all the rest are non-value investing? Is growth investing not value investing? Are the value investors only knowledgeable, and the rest blind speculators?
Share price is also price of a commodity and its level and movement is governed by the principles of demand and supply. This write-up is about various ways of evaluating stock prices and the reader can choose the one that they like.
First comes book value per share. It is defined as net worth divided by number of shares. Net worth is a cumulative figure and embeds in it performance of a company over a period of time. If net worth increases, the company must be profitable and doing well over a period of time. The share price should reflect this value. Buyers of these stocks pay a price which reflects its value.
Second comes the P/E multiple. This ratio is important as the inverse of this is the returns from the share. This ratio thus compares with the opportunity cost of investment. The true value of a share, which should reflect also the true future potential of the share, can be arrived at by multiplying the EPS of a company with the P/E multiple of the leader of the sector. This resultant price can indicate where the share price can go, if the current market price turns to be lower than the product.
Third is the text book derivation of the dividend discount model. It is defined as P = D(1+g)/(ke – g) It is interesting as P can be overestimated by considering a high value of g, or can be underestimated by choosing a high value of ke. A high discount rate reflects uncertainty about future prospects of a company.
Fourth explanation of a share price can be had from the CCI pricing model. This is based on past performance of a company and also expected future performance determined from profit earning capacity value.
The fifth explanation of the value of a share is based on free cash flow valuation. Free cash flows have been termed as “Economic Moat” in the literature, and the valuation is based on expected future cash flows and also discounting.
Tamal Datta Chaudhuri