Stock Market Terms: Valuation
I have a reader question today. It has to do with one of the common stock market terms:
I hear a lot about “valuation” with regards to stocks. What exactly is valuation?
Basically, stock valuation represents attempts to determine the fair value of a stock. This means that valuation is the process of trying to determine how much a stock is worth — and whether its worth is in line with its price.
It gets a little complicated. Especially since there are several theories of stock valuation out there.
Efficient market
One theory is that if a stock market is well-organized, and if there are many transactions, then the stock price of a share will be in line with its value. This may not always be the case, though. As you know, though, the psychology of investors can play a role in inflating a price above, or in depressing a price to below, its true value.
Perceptions of how well a stock or a sector is doing can affect the stock price as people buy or sell in fear or in expectation.
Discounted cash flow
This method of valuation is a little different. The idea is to take into account a risk premium (or the expected rate of return beyond the risk-free interest rate) in a discounted set-up. Future profits and cash flow are discounted in order to offer a present value. The idea is that there is a time value for money, and future profits can be discounted according to such factors as risk. This is the most commonly accepted method of stock valuation.
If you are still interested in learning more about stock valuation, you can watch this video explaining the basics of stock valuation:
Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss.
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stock market, discounted cash flow, market efficiency
