Summary

The provided content discusses the concept of stock valuations, emphasizing the difference between price and value, and introduces methods for determining the intrinsic value of stocks, including the liquidation value and the Dividend Discount Model.

Abstract

The article "Introduction to Stock Valuations" delves into the nuanced relationship between the price of a stock and its underlying value. It begins by clarifying that while price is a straightforward figure representing what one pays for a share, value is a more complex and subjective assessment. The text underscores that a fair price is one that aligns with the perceived value of the stock, which can be influenced by factors beyond the current financials of a company. The piece also touches on the concept that a company's value is divided among its issued shares, affecting the price per share, and cites Warren Buffett's philosophy that it's preferable to invest in a great company at a fair price than a fair company at a bargain price. Furthermore, the article explains that stock ownership equates to partial ownership of a business, whose value can be theoretically calculated by liquidating its assets and accounting for future earnings through discounted cash flow analysis. The upcoming article will explore the Dividend Discount Model as a valuation tool. A disclaimer notes that the information provided is for educational purposes and the author is not liable for its use.

Opinions

The author suggests that price does not always equate to value, emphasizing the importance of assessing whether a stock's price reflects its true worth.
Value is described as subjective, with the adage "Value is in the eyes of the beholder" indicating that different investors may assign different values to the same asset.
The author echoes Warren Buffett's investment wisdom, advocating for the purchase of high-quality companies at reasonable prices over mediocre companies at seemingly attractive prices.
The article posits that understanding a company's liquidation value provides a baseline for its minimum worth, which is crucial for investors to consider.
Peter Lynch's opinion is referenced, advocating for investment in businesses that are so well-structured that they could be run by anyone, implying the importance of a company's long-term sustainability and management quality.
The author asserts that a rudimentary valuation model should account for both current asset values and future earnings, discounted to present value, to capture a more comprehensive picture of a company's worth.
The article concludes with a forward-looking statement, indicating that the next installment will delve into the Dividend Discount Model, hinting at the importance of future dividends in valuing a company.

Introduction to Stock Valuations

Value Vs Price: What’s the difference?

Background

Before we begin exploring stock valuations, it is important to understand a concept that is applicable to everyday life but it is not something we often think about.

What is the difference between Price and Value?

Every time you buy something, you will be quoted a price. Everybody understands price. It is how much one asks for a specific product or service. The question then becomes, is the price you are being asked for, a fair price?

Does the price you are being asked to pay, correspond to the value of the product? If it does, then one could say that you are being asked a fair price. However, once you start thinking about this; it soon becomes complicated. What is the value of a product? How can one derive such a thing, as value.

Value is a subjective thing, and there is no one correct answer. Why would the value of a loaf of bread be £1.49 and not £1.50. As the saying goes, “Value is in the eyes of the beholder.”

Investing in Stocks

When you are looking to invest, you will be quoted a price. That price corresponds to the price of a single share. At this point, you need to determine whether the price you have been quoted, is a fair price. Are you willing to part with your money, for that price?

I know what you’re thinking; Find the stock with the cheapest price! That way you will have the paid the least amount for the most value, correct? Wrong! You see, each company is allowed to issue as many shares as they want. That means that even when assuming that all companies have the same value, they would still have different prices.

“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price” — Warren Buffet

Imagine you have a pie that costed you £40. If you split the pie in 4 pieces, you would likely charge a minimum of £10; however if you were to split the pie in 8 different pieces, then you would need to charge a minimum of £5. It’s the same situation with stocks. Each company has some value, which is then divided to each share issued.

Therefore, when attempting to determine whether a share is valued fairly, you need to determine the value per share and compare it against the price per share.

Finding Value in Stocks

Before we begin exploring different ways of determining the value of stocks, we first need to understand some basics. When you buy shares in a company, you essentially become part owner in the business.

A business, is essentially a living, breathing organism. It has money coming in, money going out and it’s evolving all the time. If you were to freeze time and take the company apart as it stands right now, you could sell away all the different parts. You could start by paying off any money its owed from the cash held by the company and keep what remains. Then you could sell off all the assets (machinery, patents, etc) too. Whatever remains, if anything, can be divided by the number of outstanding shares to determine what each share is entitled to. This is often known as the liquidation value of a company.

“Go for a business that any idiot can run — because sooner or later any idiot probably is going to be running it” — Peter Lynch

At a bare minimum you know that the company is worth, or valued, at least that much. However, as we said, a company is evolving all the time. The assumption is that the company will be profitable this year and for many years to come. Therefore, we also need to take this into consideration when determining the value of the company. Future earnings, or cash flows, will need to be discounted to the present value of money. This way, we have essentially built a rudimentary model that would allow us to value any company we want.

In the next article, we will cover the Dividend Discount Model; a model that assumes that the value of a company is derived by all of its future (forecasted) dividends.

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