Valuing a stock: Accuracy or Consistency?

Now a days you switch on to any TV business channel and you will see the channels flashing target prices for a few stocks. And sometimes it becomes eyecatching to see the target price of a stock is close to two times the current price or even more. So how accurate are these forecasts and above all, is there any tool that can value a stock so accurately? As investors, we should always know that if the exact price of a stock can be calculated, then that will kill the very existence of the stock market.

Since the inception of stock market, hundreds of people have tried to devise certain mathematical models to value a stock. The most popular of those is the Discounted Cash Flow method. This is nothing but forecasting the future cash flow per share and discounting all such future cash flow by a certain factor. For example if we forecast Stock-A to have a cash flow of $1 every year and we want to discount it by a factor 0.1, then the value of Stock-A is $10. The discount factor is generally decided by the risk associated with the stock. Although the calculation looks too simple, there are major issues involved in such type of calculation.

The first issue is forecasting the future cash flow. As we all know future is full of uncertainties, so nobody can forecast the future with accuracy. Then the other major issue is finding out the discount factor. Although tools like CAPM are popular, but I believe these tools are more useful for academic purpose rather than investment purpose. From our example of Stock-A, we can see that by changing the discount factor to 0.08 and future cash flow to $1.2 every year, the stock price will become $15, that is a 50% increase. And forecasts in both the scenarios can be sounded logical and honestly speaking very hard to say which one will be more accurate.

Again as investors, we have to accept the fact that if my valuation model gives a value that is two times the current market price, then that says that the whole bunch of investors are wrong, except me. So in my opinion, we should not subscribe to such views as target price provided by certain research houses involes many assumptions and perceptions.

Then the next question, are we saying that all these models are useless. Absolutely not. I would say that to be successful, more than accuracy, consistency is the crux. If we are consistent in our assumptions when we try to forecast the future cash flows as well as discount factor, then we will get a relative picture of the stocks. Doing that exercise we can identify those stock that are the cheapest among all in a particular sector and thus help us to pick up the right stocks.

Dollar cost averaging

The spectacular economic growth that India witnessed over the last few years has generated tremendous interest in stock markets from the Indian middle class. A significant portion of the salaried people are now switching their interest from traditional forms of investment like Fixed Deposit, Gold, House etc to equities. However as this trend is new, there remains a lot of myth on this issue of investing in equity. A major concern is the idea that stock market can give high return in quick time. This idea leads to speculation among people who are exposed to stock market for barely a few months. And the end result is always disastrous. I have seen people losing money at a rate much higher than the rate at which the market falls. That creates such a big panic that people exit from the stocks, taking a huge loss on their investment. So the first experience of stock market turns out to be an ugly one. Even more disastrous is people exiting from those stocks and then buying some other stocks when the market again starts picking up. A few cautious approaches will help in preventing such things happen again and again. One such approach is dollar cost averaging. This is nothing but investing in stocks regularly and at a rate which automatically takes care of the high or low valuation of market. Decide on the ratio of your investment in fixed investment and equity. Assume it to be 50:50. Maintain this ratio throughout. When the market goes up your investment in equity will go up tilting the balance in favour of equity. To make it 50:50, automatically you have to invest less in equity and more in fixed ones. And similarly when the market goes down, you have to invest higher in equities. Such approach for a long period, I consider this to be more that 8 years, will help the return from stock market to be really good. Another important issue is the selection of stock should be proper. This can be done by selecting big liquid stocks, investing in around 10 stocks covering different sectors and avoiding penny stocks. For example one can start with 50 stocks of Nifty, select the leader from each sector, and then leave a few from some sectors where there involes a lot of uncertainty.