Stock Value and Stock Valuation Methods Explained

By David Michael L

 

How valuable is a stock? How much is the "fair value" of a stock? How much should you fairly be willing to pay for a stock?

In theory, the value of a share of stock is based on any of the following:
1) Book Value or Net Asset Value
2) Net Present Value of the Stock's Earnings (as a share of company earnings)
3) Net Present Value of the Stock's Dividends

With regard to the first method above, it is important to note that the book value of a company's assets may be different from the market value. Market value is based on what real people are offering to pay for assets, but book value is based on purchase value less depreciation; determined by using generally accepted accounting principles. For example, a company might have a building and cars which were built and purchased at a cost of one million dollars. However, due to depreciation, accountants determine that the assets are now worth only $700,000. Moreover, the company has debt of $100,000. As a result, the net asset value of this company is $600,000. If the company has 1,000 outstanding shares of stock, then each share of stock would have a net asset value of $600. Thus, using the first method, the value of our aforementioned stock is $600.

With regard to net present value of a stock's earnings as a share of corporate earnings, we can basically just say that stock value is based on the present value of all future earnings, which is then based on a large extent on the net present value formula. For example, if the net present value of all of our stock's future earnings is found to be $500, then our second method would indicate that $500 is the fair value of our stock, even if it is below the net asset value of $600 as determined in the first method above.

Lastly, let's look at using the net present value of the stock's dividends. Instead of valuing a stock by getting the net present value of earnings, we get the value of the stock by getting the net present value of dividends, often with respect to cash dividends. Why dividends instead of earnings? To some owners/shareholders, it doesn't matter how much a company earns, if the company doesn't actually pay out the cash to the owners.

Since there are different methods on stock valuation, different people have their own preference as to which style is best... depending on their own individual biases or schools of thought.

David Michael is the creator of MBAbullshit.com, a fun and free online tutorial website for lots of MBA courses and business school topics. Go to http://www.mbabullshit.com to watch a super easy step-by-step tutorial video How to Calculate Stock Value in 27 Minutes.

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