Just as with anything else you buy, stocks, too, have value and a price. Let’s take a moment to understand the distinction between these two ideas.
Price is how much an item is selling for. In the case of stocks, it’s the amount of money you would pay to buy a company’s stock in the stock market.
Value, on the other hand, is how much the same stock is really worth to you.
An Example of Common Stock Valuation
Let’s use an everyday example to understand this better. Consider a newly introduced pair of sneakers that have caught your attention. They happen to be your favorite brand and you really like the way they look.
So you set out to your neighborhood shoe shop to check them out. You find they are tagged at $100. That’s the price for this item … the amount that the store is charging.
Now you really are interested in buying these shoes. But you don’t think they are worth the hefty $100 price tag. Sure, owning them would catapult you to the realm of uber-cool. But $100?
You stop to think and conclude that you wouldn’t pay more than $75 for them. In this case, $75 is the value you’ve assigned to these sneakers
What is Common Stock Valuation?
The process of figuring out how much a stock is worth is called stock valuation. Almost all the stock purchases that we as regular investors make are common stock.
Why do this? Once we’ve assigned a value to a share of stock in a company we’re interested in, the price it’s selling for in the stock market now becomes meaningful to us. When the price of the stock dips reasonably below our estimated value, we are confronted with a good buying opportunity.
How Do We Go About It?
Several Common Stock Valuation models have been developed to value stocks. Valuation isn’t an exact science …. there is a fair amount of subjectivity and judgment involved.
Despite the subjectivity involved, taking the effort to value a stock you’re interested in is always a worthwhile exercise. When coupled with the margin of safety concept, the probability of good returns on your investment is very high.
In summary, we’ve established the difference between price and value through an example. With that background, we took a look at the common stock valuation process including the models we like to use.