If you are an investor, it’s likely that you take many different things into account when researching a company. You might research a company’s past performance, its financial ratios, competitive position, product lineup, and many other factors that could potentially contribute to its success or failure.
Let’s assume you’ve found a company that you’d like to invest in. After doing your research, you can see that it is strategically positioned with a competitive moat, has a great product lineup, has been extremely profitable, and has a strong balance sheet.
Congratulations! You’ve already finished the difficult part of the process. But now that you’ve decided that you like the company, how can you determine if its stock is priced reasonably? You’ve just stumbled upon one of the most fundamental questions of investing.
Timing is one of the most crucial elements of investing, and I would venture to guess that most experienced investors would say that it is the most difficult part. After all, isn’t the goal to buy a stock when it is a good value and before it increases in price?
As Warren Buffett says, “If a business does well, the stock eventually follows”. By this, he means that if you buy a stock in a company at a temporarily low price, it’s not clear exactly how long it will stay at the lower price, but its price will eventually follow the company’s performance.
But how can you know if a stock is a good value, or at the very least, priced reasonably?
There are many valuation methods that investors use to calculate stock value. We will focus on one of them. It is called the intrinsic value calculation method, and involves estimating the value of a stock based on its projected earnings and dividends.
Most investors are concerned about a stock’s earnings, and more specifically, its earnings per share. This is because most investors like to see that an increasing amount of a stock’s earnings in relation to his or her stake. As the amount of earnings per share increases, the more likely it becomes that the company will increase its dividend.
It’s not an exact science, but the process of calculating intrinsic value has three main components. Step one is to conservatively estimate how much a company will earn per share in net income and dividends over your investment horizon. The second step is to calculate a future stock price by how figuring out how much investors are likely to pay in the future for the earnings that you’ve estimated.
Finally, once you have estimated the future value of the stock, you can then find the present value of the future stock price that you have calculated based on the estimated ROI and your investment time horizon.