At this point, it's important to remember that a stock's value is determined by the company's underlying performance. It's easy to think of Dell as just a number on a computer screen or a squiggly line on a chart, but the reason it has any value at all is that it is a business that is growing and generating profits. Thinking of a stock as a piece of a business will be particularly helpful in understanding many of the valuation methods we will be considering in the next lessons.
There are actually two parts to the value of any business. The first part is the current value of all the business's assets and liabilities, including buildings, employees, inventories, and so forth. The second part is the value of the profits the business is expected to make in the future. Some companies get most of their value from the first part. These types of companies tend to be mature, stable businesses without a lot of growth prospects, such as utilities and real estate companies. For these firms, the assets are in place, and the future cash flow is relatively predictable.
On the other hand, some companies get most of their value from expectations of future growth and profits. These types of companies tend to be younger with a lot of growth potential. Many biotechnology companies would be included in this category.
Actual assets and liabilities are a lot easier to measure than hypothetical future profits. This is one reason stocks of younger companies tend to be more volatile than their more buttoned-down brethren. When expectations are high, the market anticipates that future profits will continue to increase, and it bids up the stock. When pessimism takes over, the market expects fewer profits in the future, and the stock price falls. Ultimately, estimating what a company will do in the future is the key to all forms of stock valuation.
Two Approaches to Stock Valuation >>