Thursday, September 10, 2009

The important thing about stock valuation

Investors often get perplexed when trying to determine the 'proper value' of a stock. And understandably so, as it can get confusing at times. As always, it can be very insightful to hear what value investing guru Benjamin Graham has to say on the subject of calculating the proper value of a stock.

According to him, in the field of analysis of stocks, one cannot presume to lay down any specific rules that will help one arrive at the exact value of any given stock. This is because when looked at practically, there is no such thing as the 'exact value' of a stock in the first place. This is true as the bases of value itself are so constantly prone to changing that there cannot be any fixed formula as such that could claim to accurately determine the exact value of a stock at any point of time.

To Graham, the whole idea of basing the value of a stock upon the company's current earnings seemed inherently absurd, since it is a well known fact that the current earnings are constantly changing. And whether one should assign a P/E multiple of 10 or 15 or even 30 times to the earnings of the stock to arrive at its 'proper value' seems at its bottom, a matter of purely random choice.

To the investors who have been tracking the markets for quite some time now, the above argument might just look right. Most of the times, it appears as if there is no scientific basis to justify the valuations of a stock. It was Graham's observation that the stock market itself has no time for such scientific evaluation. Its nature is such that it must assign values to stocks first, and find its reasons afterwards. He compared the market's position to that of jury in a court case where a man has promised a woman that he will marry her and then changes his mind later for some or the other reason. In such a tricky case, there is no sound way for the jury to measure the values involved and yet, they must be measured somehow for the purpose of arriving at a verdict that just has to be reached.

This is the dilemma that leads to a situation where the prices of stocks are not carefully thought out values but are infact the result of a lot of different emotions. And hence Graham's classic quote: "The stock market is a voting machine rather than a weighing machine." The market, in effect, responds to actual data, not directly but first it impacts the thinking of the buyers and sellers and through this thinking, the prices. In other words, how much the price of a stock changes in reaction to a new information is not based on some exact calculation. The changes in price are infact arrived at through a filter of human emotions and compulsions.

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