STOCK VALUATION AND INVESTMENT DECISIONS
Obtaining a standard of performance that can be used to judge the investmentmerits of a share of stock is the underlying purpose of
Astock’s intrinsic value provides such a standard because it indicates the futurerisk and return performance of a security. The question of whether and towhat extent a stock is under- or overvalued is resolved by comparing its cur-rent market price to its intrinsic value. At any given point in time, the price of a share of common stock depends on investor expectations about the futurebehavior of the security. If the outlook for the company and its stock is good,the price will probably be bid up. If conditions deteriorate, the price of thestock will probably go down. Let’s look now at the single most important issuein the stock valuation process:
Valuing a Company and Its Future
the value of a stock is a function of its future returns,
theinvestor’s task is to use available historical data to project key financial vari-ables into the future. In this way, you can assess the future prospects of thecompany and the expected returns from its stock. We are especially interestedin dividends and price behavior.
Forecasted Sales and Profits
The key to our forecast is, of course, the futurebehavior of the
and the most important aspects to consider in thisregard are the outlook for sales and the trend in the net profit margin. Oneway to develop a sales forecast is to assume that the company will continue toperform as it has in the past and simply extend the historical trend. Forexample, if a firm’s sales have been growing at the rate of 10% per year, thenassume they will continue at that rate. Of course, if there is some evidenceabout the economy, industry, or company that suggests a faster or slower rateof growth, the forecast should be adjusted accordingly. More often than not,this “naive” approach will be about as effective as more complex techniques.Once the sales forecast has been generated, we can shift our attention tothe net profit margin. We want to know what kind of return on sales to expect.A naive estimate can be obtained by simply using the average profit marginthat has prevailed for the past few years. Again, it should be adjusted toaccount for any unusual industry or company developments. For most indi-vidual investors, valuable insight about future revenues and earnings can beobtained from industry or company reports put out by brokerage houses, advi-sory services (e.g.,
), the financial media (e.g.,
), and from
Valuation:Obtaining aStandard ofPerformance
LG 1LG 2stock valuation
the process by which theunderlying value of a stockis established on the basis of itsforecasted risk and returnperformance.
—As opticalnetworking companies caughtinvestors’ attention, theirmarket value soared. InSeptember 2000, this hypedrove the value of JDSUniphase to $96 billion, whichmade it the 36th most highlyvalued company in the world.Investors apparently turned ablind eye to the company’sfinancial results for the fiscalyear ended June 30, 2000: Itsrevenues were $1.4 billion andits losses $905 million. Forabout the same total marketcapitalization, you couldtheoretically buy all 11 of thefollowing major companies—the New York Times, Saks FifthAvenue, Georgia Pacific, T.Rowe Price, Delta Airlines,Tiffany & Co., Bear Stearns,FedEx, CVS, Gap, and JohnHancock—with aggregaterevenues of $115 billion and$6.4 billion in profits!
Jon Birger, Pablo Galarza,Laura Lallos, and Jeanne Lee, “BestStocks & Funds: Invest the SmartWay to Buy Tech,”
,October 15, 2000, pp. 65–66.