How to Evaluate a Stock before you Buy

When an individual asks the question, what is this stock worth, he/she is often asking the equivalent question, how would a stock broker value this stock, and is it worth the price its trading at? This slight change in terminology is not as simplistic as it would seem, because underlying the question is the realization that most of us who do not trade for a living have no idea of how a broker assigns value to our stock. This is dangerous to be sure, as the people who are most likely to get burned in the stock market are usually the ones who are flying blind. The purpose of this article is to describe the three basic methods of how professional investors value stocks.

Before we go on to describe the three value assigning methods of professional investors however a little side trip is necessary, because the first questions about stock valuation that should be asked are not often recognized as they are the responsibility of the person putting up the money. These questions include, how much money can I put in, am I willing to lose all of this money, and what is my investment goal? Whether a stock is worth it to ‘YOU’ often depends on the answer to these questions long before valuation techniques are employed. For instance, most working individuals do not have a lot of money to invest, often averaging $2500 or less, and so right away this would leave out stocks like Berkshire Hathaway, as well as many of the Dow Industrials which trade at too high a price for someone with $2500 to by the smallest transaction amount allowable, one lot of 100 shares. Added to this consideration is the fact that most working people who fork over a couple of grand of their hard earned money to put in the stock market are extremely risk averse, and demand at least some return on their investment. It is possible however to lose everything on a bad stock pick, and so any individual that can’t live with this possibility should seek a safer alternative. This brings us to investment goals, which only the individual can answer. Is the buyer interested in total return, or in avoiding risk? If the answer is the latter, then we can see immediately how investment goals affect the investment choice as an individual with this strategy would wind up with stocks that behave as bonds by paying high dividends, while having no real risk of the underlying company going out of business or contracting. Utility company stocks often come to mind here. With these three questions answered, the choice of stock or ‘Value’ to the individual is narrowed down considerably, and it is at this point where valuation techniques can be applied.

The three major techniques professional investors apply to determine stock value can be described as fundamental analysis, technical analysis, and a group of techniques that can be broadly termed expectations theory. Fundamental analysis uses set mathematical formulas based on several key numbers contained in the Balance sheet or Income statement of the firm to assign value. Technical analysis uses charts and graphs to determine value. An assumption underlying technical analysis therefore is that future stock value can be estimated from past performance trends. Expectations theory is harder to define. One model, for instance, looks at how many days in a row a stock has increased in price. Here the basic question runs, what would you do if your stock went up three days in a row, five days in a row, two weeks in a row? As can be seen, this is not unlike the premise behind certain television game shows where every step forward gets riskier and riskier, but the reward could be astronomical.

The two basic valuation models of fundamental analysis are the Gordon Model, and formulas that employ some form of the Capital Asset Pricing Model (CAPM)as a proxy for a firm’s weighted average cost of capital. The Gordon Model’s equation is P = D(0)/Ke – g, where P is price, D(0) is the dividend at time zero, Ke is the cost of equity, and g is the growth rate of earnings. As an example, lets set the dividend at time t = zero at $2.50, the cost of equity at 18%, and the growth rate of earnings at a whopping 10%, the Price would then be $2.50/(.18-.10) = $2.50/.08 = about $26.75 per share. If the stock we calculated here is currently trading at $30 a share, then it is overvalued and should be sold, if it trades say at $20.00 a share however, it is a good buy. As straightforward as this is, the Gordon Model has its drawbacks too however. Immediately noticeable is that a stock has to have a dividend for the equation to work, and that the growth rate of earnings must not exceed the cost of equity. Most stocks do not pay dividends until late in their life cycles, and startup companies just emerging into profitability often have exponential growth rates of earnings however. So it would seem that the Gordon model is limited to a small range of fairly mature stocks. In order to get around this, the basic equation for companies that do not pay dividends is deemed to be P = E/WACC, or price = earnings divided by the weighted average cost of capital. The weighted average cost of capital can be calculated using the CAPM model among many other methods. The CAPM formula is WACC = RF + b(Rm-Rf), where Rf is the risk free rate of return (usually the three month T-Bill rate), b is beta (a statistical measure of how volatile a stock is as compared to normal market returns), and Rm is the expected return on the market. (in this case what ‘you’ expect the stock should return.) As an example, lets say a company earns $2.50 a share, Rf is 3%, beta is 1, and we expect 7% return on our money per year, then the WACC is .03 + 1(.07-.03) = .07, and the expected stock price is somewhere around $2.50 x 14, or about $35 per share. Anything above this figure is deemed overvalued while anything below it is deemed a bargain.

By now, the reader should begin to get a sense that a major drawback of fundamental analysis is that the number crunching involved renders the method difficult. A simpler idea of where a stock is going would be to look at a picture of it’s past prices, and see if a trend can be detected. This is the basis of Technical analysis. It is utterly beyond the scope of this article to do justice to this school of thought. Thousands of books have been written on the subject. Terms such as shoulders, base of support, and the like have become an everyday part of an investors vocabulary. However, just a couple of points should suffice to demonstrate the strengths and weaknesses of the technique. One strength of technical analysis is it teaches an investor not to buck the trend. If the graph of a stocks price has trended steadily but slowly upward for over a year, then it should be expected to grow slowly in the foreseeable future. Such a stock is a buy, or hold, and a contrarian approach of selling this stock because we deem ourselves to hold some sort of special knowledge that the market doesn’t have is probably going to be severely published. A weakness of the technical analysis approach however is that performance in the future does not always depend upon past performance. If this were so, then we would never see any stock skyrocket on unexpected good news like a takeover offer out of the blue, or a bubble in a market burst. The latter example of the bubble bursting is a caution that graphs do not capture ‘underlying value’.

This brings us to our last method, expectations theory. What the model that was developed above is basically saying is that we expect a stock to go up on good news, but for every stock that trades on the open market there are at least twenty days in every month where there is no news, economic data, or hard numbers being generated on which to value the stock. In such a case, prices during those twenty days would be expected to fluctuate randomly between gain and loss. Thus, statistically I might get three days in a row of gains, and that might be somewhat common, but if I get seven days in a row of gains in the absence of any news then that is very improbable statistically speaking, and selling some of the position to take profit would be feasible. Such an approach seems logical and true. However, carried to its extreme, the account on just a single stock could be churned, with trades being consummated at least once a week, and excessive transactions costs as the result. Such an approach is also gut instinct. How many of us are good at judging exactly when the other guy will buy or sell? Timing is at a premium in some of the expectations approaches.

Finally, for those individuals where all of the above approaches seems to complex, there is often the reliance on ratios to judge a sound investment. The four main ones are P/E, P/D, P/B, and P/S, or Price/earnings, price/dividends,price/book, and price/sales. P/E is by far the most common so we shall discuss it here. The general rule of thumb on many years of return on the DJIA is that stocks are solidly valued around a P/E of about 15 – 18. This is the equivalent of saying that the average WACC for a modern corporation runs around 7 or 8%. From this, it becomes clear that stocks with a superior p/e of around 10 must be undervalued, and those with high p/e’s of 30 or more must be overvalued. As a general rule of thumb, this is not bad. However, there are things to look out for. First and foremost among the things to look out for when using the ratio approach to invest is what earnings are being used to calculate the p/e, expected earnings or reported earnings. If expected earnings are used, they could be much higher than the reported earnings as they take into account future revenue streams. The higher expected earnings would then be divided by the same wacc as the reported earnings, resulting in a very high p/e, but in this case the high p/e would not be bad so long as the company actually made it’s earnings forecast. However, the high p/e is also a double edged sword as this is why we also see stocks take a tumble when a corporations earnings don’t meet expectations! (Yet another form of expectations theory). On the other side of the coin, if a company has a low P/E, ask yourself why the superior earnings implicit in that number have not been rewarded by the market through a higher stock price.

Whatever method of valuation is chosen depends on what is easiest for the investor to understand, what fits the level of risk he/she is willing to assume, and what amount of time he/she is willing to devote to each method. The author hopes the thumbnail sketch given above is useful in sorting out which one is applied.