When purchasing a stock, it is important that we remember when you buy a stock, you are actually purchasing partial ownership in an actual company. This post will attempt to help you learn how to place a value on a company to determine what the company is actually worth, compare that to the stock price and then determine the value of a company and hopefully help you make a smart investment.
What Is Discounting?
The idea of discounting is a bit confusing at first. Discounting is the idea that $1 given to you today is worth more than $1 promised to you in the future. The longer the time period until the promise is paid, the less that $1 is worth. The promise of money in the future means you get no interest on the money and have the uncertainty of whether or not you’ll actually get the money in the future!
The promise of money in the future is worth less than having money today.
What Is A Discount Rate?
A discount rate is a discounted rate on money promised to you in the future. It is calculated by a risk-free interest rate. Once we have the discount rate, we can divide any amount of money in the future, we can get the present value by:
Present Value = (Promised Amount / (1 + discount rate) number of years
The Present Value is always less than the promised value. This is because I miss out on interest and have the risk of not getting my money back.
How do I use Discounting to find Undervalued stocks?
By buying a stock, you are essentially being promised future payments in the form of earnings. Using discounting of future earnings to value a stock is known as “discounted cash flow analysis” or DCF.
What Is A Margin of Safety?
The concept of the “Margin of Safety” was introduced to us by Benjamin Graham. Graham noted that no one can predict the future. Estimates at future value are at best, an educated guess. Included a margin of safety in stock valuation which means even if the company was not correct with its valuation, you could still make money.
Margin of Safety = (Valuation – Stock Price)/Stock Price
According to Graham, any margin that was less than 40%-60% was too risky and not deemed profitable.