How To Value a Stock

How To Value a Stock…and How Pricey Stocks Can Keep Rising
By Dr. Steve Sjuggerud, President, Investment U
Friday, May 16, 2003: Issue #239

EBay, Yahoo and their dot-com friends have risen by 100% or more since October… and they were already expensive to start with!

These stocks are now trading at a price-to-earnings ratio of 100 (a ratio of 15 is historically average for stocks). What’s going on, and can pricey stocks continue to rise?

Yes, stocks can continue to rise because in the short term it doesn’t matter if a stock is “expensive.” In other words, the fundamentals are irrelevant to stock price action in the short run. But in the long-term, fundamentals are all that matter.

In this issue, we’ll take a look at how to value a stock, and get a feel for what ‘value’ is and what it means in the short and long term.

Understanding this will let you make better decisions about where to invest.

What Value Is in Stock

When I say “fundamentals” above, I’m talking about VALUE-whether a stock is expensive or not based on its earnings, sales, debts or whatever other criteria you examine. However, in the short run, it doesn’t matter how expensive a stock is. Really.

In the long run, the stock market reflects value. However, as Keynes noted, “In the long run we’re all dead.” It may take many years for Wall Street to return to proper “value.” In the short run, other factors rule. We’ll cover those next. But first, let’s consider how value may be useless in the short run…

The concept of “value” is difficult… How do you determine what something is worth?

Some people like to add up the costs, and say that’s the “floor” value. Consider real estate for example… If a piece of land costs $75,000 and it costs $150,000 to build a house, then that house should sell for $225,000 or more. Or if it costs $275 for a mining company to produce an ounce of gold, then the price of gold shouldn’t dip below the cost to produce-or so the thinking goes.

While many people believe this is what value is, this line of thinking is actually complete nonsense. The price of anything is what someone is willing to pay for it. For example, it may cost $400 to produce an IBM Selectric typewriter, but people may only be willing to pay $40 for one.

In this example, if people are only willing to pay $40 for that typewriter today, then one of two things must happen: Either IBM must lower its cost of producing a typewriter dramatically, or IBM must go out of the typewriter business. These are the two things IBM has control over. IBM has no control over the public’s desire for a typewriter, for better or worse.

Beyond Value: What Matters In The Short Run for Stocks

In the short run, two things seem to influence prices: perception of risk and the prevailing trend.

If the public is scared, or “risk-averse,” the fact that it cost $225,000 to build a house is completely irrelevant-they’re not opening their pocketbooks, so that house could ultimately sell for less. However, if people are not risk-averse, they may be willing to pay much more than $225,000 for that house.

Back in the stock market of October 2002, people were extremely risk-averse, and stocks were at lows. The Nasdaq Index has risen some 35% since then, as people have become willing to take risks again.

The other factor in the short term is the prevailing trend. If for no other reason than EVERYONE ELSE is watching the prevailing trend in the short run, this concept seems to be self-fulfilling. We’ve seen trend followers in the currency markets and the commodity markets for years. And in recent years we’ve seen plenty of “technical analysts” – trend followers – in the stock market too.

Watching Both The Fundamentals And The “Technicals”

Analysts that just paid attention to the fundamentals in the U.S. dollar back in the 1980s lost a ton of money… The prevailing trend in the dollar was up, defying the weak fundamentals of the dollar. The fundamental analysts would have eventually been proven right if they could have held on for seven years. Unfortunately, most traders betting on the fundamentals went bust before they could be proven right. As the old Wall Street saying goes, “The graveyards of Wall Street are littered with those who were exactly right… but early.”

The same was true for stock prices in the late 1990s. Anyone betting against the Nasdaq in 1999 would have gone bust before he was proven right.

The market reflects the fundamentals, in time. But in the short run, anything can happen. So yes… absolutely… pricey stocks could rise in the near term.

Good investing,

Steve

Today’s Investment U Crib Sheet

When both the fundamentals and the prevailing trend are in your favor, it’s time to buy with all you’ve got. Right now, the trend is in our favor. But stocks are expensive. Therefore, when the prevailing uptrend ends and you’ve got no leg to stand on, it’s seriously time to lighten your load.

People often ask me what use to track the fundamentals and the trends. Yahoo’s financial information is great, you can do both there for free. BigCharts.com allows you to do some custom technical analysis for free. To do fundamental research on your own, Microsoft has an outstanding free tool:http://moneycentral.msn.com/articles/common/finderpro.asp