You've heard the line: "It's a buy! XYZ'sstock is worth $40 but is trading at only$30." Analysts and money managersmake comments like this all the time.You've probably wondered, "How do they know howmuch a stock is worth?"
Financial theory offers several methods for valuingstocks (ie, calculating how much a stock is worth), andanalysts use one or more of these methods. But none isas scientific or accurate as, say, measuring your bloodsugar level. Stock valuation is a complicated art and science.Understanding the basics will help you decide ifyou should rely on anyone's opinion on what a stock isworth to make investment decisions.
The most popular stock valuation method is calledrelative valuation. It comes in many flavors, but theunderlying concept is simple, similar to a houseappraisal. When evaluating your house, you assess itbased on the known values (ie, the recent sellingprices) of similar houses. You start by looking at theprices for which similar houses in your neighborhoodrecently sold, and then make adjustments for the differencesbetween these houses and yours (eg, renovationsand additions).
But relative valuation can be misused and evenknowingly abused when applied to stock valuing.Consider the following difficulties:
• Subjective comparisons. Which companies are"similar" to the company whose stock you're tryingto value? Intuitively, you would consider companies inthe same industry as similar, but they tend to havemajor differences. Making adjustments for these differencesis more complex than adjusting the price of ahouse's renovation.
Analysts have to make a lot of subjective adjustments.Just as you're biased, making high adjustmentsin valuing your house, analysts are often biased, makinghigh adjustments in valuing stocks they like orwant to promote. This is one of the ways analysts justifiedrecommending stocks at outrageous prices duringthe market bubble.
• Widespread overvaluation. What if most similarstocks are overvalued for some reason? Then the valuationof a stock based on those overvalued stocks wouldlead to another significant overvaluation. Once again,this was a major problem during the bubble. The overvaluationof stock A justified the overvaluation of stockB, which led to the overvaluation of stock C, etc.
So, when an analyst says a stock is worth $40,they may really be saying, "This stock is worth somewherebetween $20 and $50; I don't know exactlywhere, but here's an exciting number." You have totake those valuations with a small shaker of salt andnot get too carried away.
Valuing is largely an art, and true masters of it arerare and hard to identify. Most stock pickers can'tacquire a mastery of stock valuation through readinga few how-to books. And even the true masters, likeWarren Buffett and Benjamin Graham, insist thatbecause their valuation of stocks can be wide off themark, they insist on maintaining a large margin ofsafety by buying stocks only at a significant discountto their estimated valuations.
If you're going to invest on your own, your best betis to stick to index funds because they don't rely on valuingstocks. But index funds have their share of problems,too. At the height of the market bubble, index fundswere highly overvalued and risky.
If you want to avoid the problems inherent in indexfunds or shoot for somewhat better investment resultsand risk control, find a knowledgeable investment advisorand be realistic about their and your capabilities.Winning the game of investing doesn't require genius.Knowledge, discipline, patience, and a little bit of luckcan produce excellent long-term results.
Chandan Sengupta, author of The Only ProvenRoad to Investment Success (John Wiley; 2001)and Financial Modeling Using Excel and VBA(John Wiley; 2004), currently teaches finance atthe Fordham University Graduate School ofBusiness and consults with individuals on financialplanning and investment management. He welcomesquestions or comments at email@example.com.