Determination of Stock Market Valuations - Part 1/3

Did you ever wonder how the market comes up with the price of a stock? To the average investor, it might seem like an exercise in voodoo, and quite honestly, I believe that would not be that far from the truth. Let's start with the theory behind stock market valuation. One of the most widely held techniques for valuing stocks is known as the discounted cash flow (DCF) methodology. It states that the value of the company can be derived from taking the current cash or accounting value based on the most recent balance sheet and adding the expected present value of net cash coming into the company in each successive period. For those without a finance background, the present value refers to the practice of discounting future periods by a required rate of return. For example if I required a rate of return of 10% a year from now, the present value of $10,000 cash flow would be $9,090, etc. The more uncertain one is of the cash flows, the higher the required rate of return.

It is not my purpose in this article to go into the intricacies of a proper DCF analysis. In fact, after spending many years on Wall Street I can tell you that I doubt the majority of analysts and portfolio managers are in the practice of performing such analysis. The biggest reason is that a proper DCF calculation is time consuming and difficult, but more importantly there are significant practical problems. Other than the fundamental problems of dealing with uncertainty years into the future, the choice of the discount rate for a given equity is one of the biggest problems with discounted cash flow analysis. While there are many quantitative methods for determining this rate based on volatility, correlation with the general market, or more sophisticated methods, the big problem is that the valuation is highly sensitive to small changes in this rate. Estimating the sustainable growth rate in out years is also difficult and highly effects the valuation. Arguably one can pick a wide range of values by just tweaking one's analysis because of the highly nonlinear aspect of the calculation. Obviously this is problematic for someone trying to invest and thus most investors either skimp on a very simplistic DCF type of analysis or utilize something more expedient. I would argue that absent very sophisticated algorithms, virtually no one on Wall Street really knows what the value of these stocks are, and this is something that I believe every investor should be aware of when listening to TV pundits.