Who decides the value of a bag of fresh apples at the town square market? You do, and the stand keeper and other people who are interested in the apples too. The same goes for stocks.

What is a ‘market’?

Together you make a market for apples. An apple market works in the exact same way as the market for stocks (although there are arguably many more different types of buyers and sellers of equities – some of them totally ignorant of and disinterested in valuations).

The analogy goes further: let’s say you refrain from eating those apples and instead sell them to somebody else. Or you could simply enjoy the fruits of your labor and eat them (the inherent user value, the pleasure of eating the apples, is called the “intrinsic value” in finance lingo).

Intrinsic value

The intrinsic value doesn’t require anybody else’s approval or money. You don’t care what the market price is, or if the apples are in demand by others, you just eat and enjoy their actual tangible value. In equity terms, that would be the dividends. Alternatively, just one step away, the company earnings or cash flow.

Profits vs cash flows

By the way, cash flows and profits are almost the same thing (over a company’s entire life span, they actually are the same thing). However, there are differences based on the amount of money temporarily tied up in investments and receivables compared to the timing of the company’s ability to service its payables and the depreciation rate of its assets.

Two valuation methods: They are a combination of market dynamics, i.e., what others are willing to pay, and the actual intrinsic value, i.e., what you get directly from the company in terms of dividends or more indirectly in the form of company profits: what you can “eat”, regardless of the market’s ups and downs.

Price vs. value

Two measures are used to evaluate a company: company value and company market price.

The value is the net sum of cash flows. The market price is simply the stock price times the number of shares. The market price is governed by imagination and sentiment, i.e., fantasy and predictions about the unfortunately (mostly) unknowable future. The market price, at times, can be higher or lower based on actual historical value creation. Some companies are priced at 100 times sales, and others at just 0.1 times sales, depending on the market’s faith in the company’s value creation potential – assessed from historical achievements. Some stocks enjoy an earnings multiple of 100x last year’s profits, while others just 2x, and some even exhibit a negative P/E multiple (if the P&L showed a loss). 

P.S. The reported-backward looking P/E ratio is mostly useless, but it’s a good starting point for discussing the value concept per se.

Valuation in practice

The price P of a stock can be broken down into its fundamentals F, and its valuation V. For example, a company that makes 1 million in profits and is valued at 15 times those earnings has a total price tag of 15 million. You pay 15 million today to buy the rights to 1 million annually. Let’s say the company has one million shares; then the price per share is 15. The profit per share is 1 (aka EPS=Earnings Per Share), and the valuation multiple is 15.

In the RANGEr method, a likely future price range for a stock is estimated by forecasting a range of profit outcomes combined with a range of valuation outcomes. The forecasts are based on historical records for 1) the company itself, 2) companies with similar characteristics, also known as “peers”, and 3) the overall stock market

Suppose a future valuation range of 12-18x seems reasonable given all relevant data, and the best estimate of the normalized profit per share for a certain year is $2. In that case, the forecast price range for the stock is… [TIC]

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