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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?

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December 2016

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.

December 2016
December 2016
December 2016
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