This article was written in October of 2021.
Here’s a quick, four-word tutorial on how to invest in stocks: Buy low, sell high!
Unfortunately, it’s not so simple. There’s more to successful investing than picking winners from a list of stock tickers and prices. And, for many, those numbers are complete gibberish. What does a stock price really mean? Is a $30 stock a better investment than a $300 stock? How do you know what these investments are actually worth?
What’s in a stock price?
A stock price is the dollar amount at which investors are buying and selling right now. It represents what the collective “market” considers one share of stock to be worth.
Because hundreds of millions (even billions) of shares can exist for each company, it is important to assess what the entire company is worth. This is called market capitalization (a.k.a. market cap) and can be determined by multiplying share price times the number of outstanding shares.
Consider Apple, which has a stock price of about $145 and 17 billion shares outstanding at the time of this writing. This equates to a market cap of $2.5 trillion, which is the highest in the world.
Now compare Apple to Celanese Corporation, a chemical company you’ve probably never heard of based in Irving, TX. Celanese has a stock price of $147, which is higher than Apple’s. But with 111 million shares outstanding, Celanese has a market cap of only $16 billion. Clearly, when assessing the entire company, Apple is worth much more than Celanese, even though it has a lower stock price.
Valuing a stock
Comparing two companies on stock price alone is not very useful. But for any given company, how do you determine what a “good” stock price is? At what price should you buy? Or sell?
The world of investing offers many questions with no clear answers, but as investment managers, we must create a framework for decision-making. Buy-and-sell decisions cannot be made haphazardly.
To understand what a stock is worth, we must first distinguish between price and value.
A stock’s price is objective and observable. (Turn to any financial media and you’ll be inundated with them.) Although the term value seems similar to price, we think of the two quite differently. Value is subjective; it is just one investor’s opinion of what the price should be. For example, an investor who values Apple stock at $160 would surely buy it if the price was only $145. However, someone who values Apple at $130 per share would not.
Value can vary wildly from one investor to the next. Never has this been more evident than in 2021, where “investments” such as meme stocks, non-fungible tokens (NFTs), and cryptocurrencies that blur the line between heavy speculation and scam have gone mainstream. While some people are spending millions on digital pet rocks, other investors are left scratching their heads.
No matter your view on a stock’s value, it is price that ultimately determines your investment return. The future will reveal if today’s price was too high or too low. Therefore, investors who can sniff out the most accurate value of a stock ahead of time stand to make better investment returns. And because no crystal ball exists, many stock valuation techniques have been devised to help make investment decisions.
The BCWM Portfolio Management team employs a wide range of stock valuation techniques, but one tried-and-true method is Discounted Cash Flow (DCF) modeling.
DCF modeling involves making financial projections for a company, such as revenue growth, profit margins, tax rate, etc. Together, these projections are used to forecast how much cash flow the company will generate over time. Then, a mathematical process (called “discounting”) is used to convert the projected future cash flows into a single value as of today (called the “present value”). This present-value number is our estimate of what we think the stock price should be.
After building the DCF model, we can run different scenarios to see how they might affect the stock’s value. What would happen if profits double next year? Or if a recession hits and profits plummet before recovering a couple of years later? What if corporate tax rates increase? Or labor costs rise? What would need to happen for the stock to return 5% a year? Or 15% a year?
BCWM clients may find this sort of scenario analysis familiar. That’s because the math involved is the same as the risk analysis we perform on retirement projections.
Investing is an inexact science. However, DCF modeling is one tool that gives us a framework for determining the value of a stock.
Before we invest, we also check that the stock fits within the broader portfolio strategy, to deliver clients the return they need with as little risk as possible.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.