This blog is a part of our new series written by Makenna Cooper, finance student at Berry College. Makenna is our 2021 Summer Intern. This new blog series is based off excerpts from the well-known book, A Random Walk Down Wall Street by Burton G. Malkiel.
If you plan to invest your money in the stock market, it is important to understand the value of a stock. You may ask, “Shouldn’t the value of a stock simply be the price of the stock?” However, valuation is not dependent on price alone. Because of social, political, and environmental factors, the value of a stock is ever-changing and unpredictable. A foolproof formula to find the value of a stock has yet to be created, but investors have developed strategies that can predict the success of a stock slightly better than chance, although chance may still prevail. There are two popular approaches to calculating a stock’s value: discounting and psychological analysis.
1. The Discounting Approach
The first approach to stock valuation, discounting, is all about math. It is based on the idea that each stock has an intrinsic value that you can compare to its current price to make investment decisions. In order to calculate the intrinsic value, investors will first calculate a stock’s expected worth at a certain point in the future. For instance, a stock with a 10% rate of return that is expected to be worth $20 in one year is worth $18 currently. Using the discounting approach, investors also factor in dividends to the stock’s future value if they are paid by the firm. Higher dividends and growth rates indicate a higher intrinsic value of a stock because it is expected to yield higher returns to the stockholder. Once investors discount this future of expected cash flows value back to the present value, they compare it to the current stock price to decide whether or not it is a wise investment to purchase.
2. The Psychological Approach
Psychological analysis may not be based on figures and formulas, but it is still a valid way to value a stock. Rather than calculating the value of a stock based on its expected return, this approach looks at how others perceive a stock will perform. Psychological analysis is also focused on short-term investing because it acknowledges the fast-changing nature of preferences in the market. John Maynard Keynes best describes this approach in terms of a beauty contest in his book, The General Theory of Employment, Interest and Money (1936). In this beauty contest, judges are rewarded based on how closely their top contestants align with all judges’ top contestants. To win this contest, the logical strategy would be to choose the contestants who are the most objectively beautiful according to current standards and who the judge believes most people will choose. Applying this approach to investing, psychological analysis argues that buying stocks that society perceives to be valuable are the most valuable. In cliché terms, “perception is reality.”
Which Method is Best?
Whichever method you use, if the value you calculate for a stock is greater than its price, then you would most likely purchase the stock. If the value you calculate for a stock is lower than its price, you would not purchase the stock. In the end, neither method is proven to be more effective than the other due to the volatility of the market. Yet, having an understanding of these two methods can help you make more informed investment decisions that could help limit risk while maximizing profit.
Summer Intern / Berry College Student