What is the most efficient and valuable method to value a stock?
Between book value, enterprise value, and the discount flow analysis value, which method is most efficient and accurate in determining the value of a stock?
You have asked an excellent fundamental question, how should we value a stock? Let's look at each of the approaches you have raised.
Book value is merely an accounting value. It reflects the difference between asset value (based on historical costs) less the debts and other prior liabilities. So, if the historical asset value based on the original cost does not reflect the current value, it can be a very misleading statistic. For example, many integrated steel companies had very high cost assets based on their historical valuation, yet were no longer economic and produced little cash flow or earnings. Companies like this traded at a discount to their book value, but were not really bargain investments. One other accounting wrinkle that I should mention. When companies are buying back a lot of stock at prices that exceed their book value, these actions actually reduce the book value. Consequently, there are many companies that have had active share repurchase programs where the book value can even be negative. Yet, many of these companies continue to grow revenues, cash flows, dividends, and earnings. There are other companies which may have understated values, for example, raw land that has appreciated over time, but is still reflected "on the books" for its original cost. So, book value is not a reliable determinant of valuation.
Enterprise value takes into account the stock market's assessment of the value ( the stock market price) plus the debt of the company less any cash holdings of the business. It's as if you were buying the entire business, paying off all the shareholders, as well as the debt holders, but you would finance part of this transaction with the company's own cash holdings.The cash is subtracted because it would reduce the cost of buying the entire business. Sometimes, one can find stocks with negative enterprise value, that is, the cash on the balance sheet exceeds the valuation of the rest of the business. This can be helpful in finding bargains.
The discounted cash flow method is one of the most commonly used approaches by professional analysts and investors. As others have described, it does determine the value of a business by taking a present value of all future cash flows from the business and adjusts these for the liabilities. However, there is "art" in using this tool. One must be able to make reasonable assumptions about the future profitability of the business and obviously that can change with competition and obsolescence. One must make assumptions about what sort of discount rate to use. That discount rate reflects not only the "cost of money," or the cost of financing, but your desired rate of return. In other words, how much return would you expect from this sort of a business. If a business has a highly predictable cash flow, you probably would demand a lower return. On the other hand, if the cash flows were somewhat unpredictable, or competition in the industry was rampant, you would want a higher rate of return, so your discount rate should be higher.
Most advisors do not attempt to value individual securities, but prefer to utilize professional active investors through Separately Managed Accounts or mutual funds or alternatively, use passive investing approaches. Proper security analysis requires education that goes beyond the scope of Series 7 holders or even CFP certificants. Individual investors should be mindful of the risks associated with security selection and inadequate diversification.
The discounted cash flow approach is the best tool that we have to determine "intrinsic value," but it does rely on assumptions which may be unrealistic and discount rates which depend on an assessment of the riskiness of the cash flow.
In my opinion, the most efficient method to calculate the current fair value of a stock is some form of a discounted cash flow model or any other analysis that takes into account future assumptions and the time value of money.
Essentially, book value per share shows the amount that is left for common shareholders after all debts have been paid under current assumptions. Complex accounting methods can make it challenging and create a lack of transparency when attempting to value a company's assets and liabilities. Book value per share does not account for any future assumptions of the company, it only considers current conditions. This is an incomplete analysis when attempting to value a stock; you wouldn't sell your business for $100K if your building and equipment cost $100K (minus any debts) and that business has been earning you $1K per year.
Discounted cash flow (DCF) methods consider future potential payoffs of an investment and puts the value in terms of today's dollars. These methods can be complex and are subjective; analysts can use the exact same data and calculate different values. When creating assumptions in regards to a company, it is important to not forecast too far into the future because it is more difficult to project accurately and little changes in your equation could alter your ending valuation drastically.
When valuing a stock, it is more efficient to use methods that take into account future assumptions of the investment and put that value in terms of today's dollars. There are many different variations of discounted cash flow models, but they do attempt to account for the future of an investment which makes them more accurate than analyzing solely current information.
This can be a tough topic, but I hope you found this helpful.
The best indicator of value is the market price. The market price is the consensus price of literally millions of participants. Those who attempt to use other methods to guess if a stock is over or undervalued have a terrible track record of doing so successfully.
That is why a Harvard MBA mutual fund manager gets beaten by an unpaid monkey with a dart board fairly consistently. Typically, about 85% of stock funds are beaten by their indexes annually. Over a ten year period of time, less than 5% beat the indexes. Those are odds I want to avoid.
There are many techniques you can use to your benefit. Stock picking is not one of them.
For an investor who doesn’t have a career in analyzing securities, the best estimate of the fair price of a particular security is its current price. The current price represents the millions of estimates and forward-looking expectations made by professional analysts and traders around the world. The price reflects the future prospects and risks inherent for that particular company.
After you accept that the current price is the best estimate of a particular security, the best way to capture the benefits that stocks have provided investors over the long term is through a globally diversified portfolio of index funds. Understand how much risk you should be taking in the market and build an asset allocation that matches that capacity for risk.