I know that stock analysts like to assign values to share prices based upon earnings. Of course, earnings can be present and future (anticipated), and ananlysts devote a lot of time to studying a companies prospects for making money. It is a prime concern for investors, that the firm they own should be capable of generating profits.
Anyway, how do you avlue a company that is losing money?
For example, El Paso gas. Co,. According to their 2003 annual report, they have LOST money for the years 2001,2002, and 2003! I know that they have assets, but how would an analyst begin to assigna value to such a firms’shares?
A stock is worth exactly what someone will pay for it on an open market. If a company is losing money and has little prospect for changing that then the value of that stock soon approaches zero. See Enron’s recent plight for an example. There was no perceived real value to that company.
For a company like El Paso gas there are enough people holding the stock to give it some value. It may be a belief that the company’s woes can be corrected, the stock could be seen as cylical and currently in a down cycle, some might think that rising oil prices make the stock a bargain to hold until something turns the price around, etc.
That’s not exactly true. It has little to do with how many people are holding shares and just because a company is going out of business does not necessarily drive to price to zero.
The OP is asking how do analysis value a stock. One method is to use the net present value of a companies anticipated cash flows. The obvious flaw to this method is that the furthur you go into the future, the more uncertainty there is regarding those cash flows. The second obvious flaw is that it doesn’t work if the company is not generating cash.
Another method is to look at the current value of a companies assets minus the debt and divide that number by the total shares outstanding. This would give you a rough estimate of what the company would be worth if you fired everyone and sold everything - real estate, inventory, equipment, etc. The problem with this method is that it understates the potential value of a company. It does not take into account intangibles like intellectual capital or brand recognition. ( There may also be a difference between the balance sheet value of the companies assets and the market value but I wont get into that).
Another way to value more established companies is to compare their stocks vs other companies of similar size in the same industry. How are they performing vs their competitors.
Keep in mind that in a more or less efficient market, the stock price already reflects all the information known about a company.
Valuation is as much an art as it is a science, otherwise everyone who could pick up a finance book would be a millionare.
Past results mean very little really. A whole host of circumstances may have changed or be about to change and it is an analyst’s job to fairly represent prospects - given all that is known - with a rating/price target.
Thanks, Msmith, that’s a better explanation than mine.
I do want to point out that I said “approaches zero”. Meaning that the stock value of a worthless company is going to eventually reflect the markets’ percieved value… The key there is worthless. Few things are truly entirely worthless, save perhaps my brother-in-law.
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I think this will do better in General Questions.
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What is the standard horizon to look at? I mean, the NPV of a company if you look at 3 years is going to be a lot less than the NPV if you look at the next 10 years. Also, NPV has to assume an inflation rate, correct? What rate is used?
No you are correct. The point I was making was that there are objective ways to value an equity. Basically when you hear about analysts saying a stock is over or under valued they are comparing the percieved value in the market vs what they predict the value should be.
It doesn’t matter - as you go further into the future, the present value of that year’s income becomes less and less, and approaches zero. The calculation includes inflation/interest rates, and usually an assumption about the company’s growth.
Another factor is comparing the performance of a company against its competitors. If an airline broke even while its 10 major competitors all lost money, it would stand to reason that the airline is doing something better than its competitors, and therefore has a better chance of doing better than the industry as a whole.
Yet another is to look at the makeup of the management team. If a new team was brought in and the numbers got a little better, that’s a positive sign. On the other hand, if the CEO left and the numbers dipped, that can be a warning. If the numbers dipped, the CEO was replaced, the numbers kept dipping, the sales division was replaced and the numbers KEPT dipping, that’s a definite red flag.
IIRC, you model out say…5 to 10 years and ten model the rest as a fixed cash flow in perpetuity. Basically as JerH said, there is a formula to calculate the total NPV of a fixed cash flow extending indefinitely into the future.