October 2007
Link to FT.com version

How do you value a stock? This is the single most important question that an investor has to answer. If you cannot generate an informed estimate of value, you should not be making buy-and-sell decisions.

All rational buyers of assets go through the same exercise. They ask two simple questions: “What does it cost?” and “What is it worth?” If you can look up a stock quote, you can answer the first question. But the answer, by itself, is meaningless.

Let’s assume you like a certain coffee retailer, so you decide to buy the stock. You look up the stock quote and buy at $50 a share. Before you bought, you answered the first question, but the answer is useless in isolation. Is the stock worth $75 a share? Is it worth $25 a share?

To attribute meaning to the $50 quote, a frame of reference is required. This is provided by the answer to the second question: what is it worth? As all sophisticated investors recognise, answering the second question is the nexus around which proper decision-making revolves. If value exceeds price by a wide margin, consider buying. If price exceeds value, consider selling.

If you do not calculate value you are, in effect, a blind investor. These investors base decisions on something other than a comparison of price and value. Because they do not have a frame of reference, they make decisions based on criteria that are almost always irrational.

Many blind investors will buy a stock because it has been increasing in price. They expect that the upward move will continue. Or they sell because the price has been on a steady decline. They fear the slide will continue. In spite of the fact that price information is meaningless by itself, investors ascribe predictive power to price.

This sort of silliness does not occur with other asset classes. If your neighbour offers $15,000 for your car that you know is worth $20,000, you are not going to accept the offer. You certainly would not accept his offer of $12,000 the following week. If he followed up a week later with a $10,000 offer, you would see it as nonsense and summarily reject it.

In the stock market, investors are prone to accept a lower offer for their asset when they don’t understand value. This is particularly true when prices are volatile. When the market gets crazy, investors get crazy.

When the market is in freefall, emotions easily infect decision-making. There is an analytical void when there is no frame of reference and emotions fill that void. Investors think they can divine a pattern to the price action. The result is that, in tumultuous downward markets, they make decisions based on feelings, not facts.

It is not easy valuing stocks. Valuation calculations are difficult because businesses are moving targets. While other assets are relatively static, businesses are constantly changing, requiring frequent adjustment to valuation variables.

The valuation model used by many analysts is based on an estimation of a company’s future cash flows, discounted to present value. There are other methodologies, such as the so-called relative valuation models – that is, a company’s value is forecast on some multiple of (or relative to) book value, earnings or free cash flow.

All stocks are mispriced. There is no such thing as a perfectly priced stock. Some are mispriced by a little, others are mispriced by a lot, but all are mispriced.

No matter which valuation methodology is employed, the idée fixe for rational investors remains the same. It is to measure value and compare that to price.

The fact that price deviates from value, and sometimes by a wide margin, is welcomed by the rational investor. Other investors obsess and worry about price volatility but the rational investor understands that his potential profit rises in concert with volatility.

The difference between the annual high and low for the average stock on the New York Stock Exchange usually approximates 50 per cent. Businesses do not oscillate in value that much. The average publicly traded business increases in value by about 7-8 per cent a year, with the increase being largely linear. That means that price change greatly exceeds value change. For the rational investor, at least, that equals opportunity.