What is Value?
There are many ways to value things. A the end of the day an item can have sentimental value or personal value that gives it more worth to one person over another. It is similar in stocks, because not everybody is playing the same game. The valuation quant companies use to buy and sell stocks trying to arbitrage milliseconds is different from day traders and swing traders. For the purpose of this article I will be using Buffett's definition as I think it's the most true in the essence of what a stock is - a company. Buffett says the value of a company is how much money it will pay out to it's shareholders - you, between now and judgement day. There is one more detail, but essentially this is the definition.
Jimmy's Gum Stand
Let's take a simple example. Let's say a kid is selling gum in high school and will be there for 4 years. Let's call him Jimmy. Let's say we also know how much revenue and profit Jimmy will make in these 4 years. The first year he will make $1 per stick, sell 100 sticks for a total of $100. This is how much revenue he will make, but his profit after buying the sticks of gum and paying for a gum stand is $10. The first year he makes a total of $10, the second year he makes $20, the third year $30, and the fourth year $40. Totaling $100 for his high school career. Let's also assume that at the beginning of his high school experience he and his friend John knew that he would make a total of $100 and John approached him to sell his rights to his profits. How much should John buy Jimmy's company for?
Again, knowing that he will make $100 for these 4 years, so we would think that he should buy it for anything less than $100. Let's think about it a little more though as John could take the $100 and invest it instead of paying Jimmy it. He could invest it in bonds at a guaranteed 5% or in the S&P 500 for a more risky 10%. For simplicity let's use a 5% guaranteed bond investment. If John invested this $100 for high school, he would have $121 at the end. If he bought Jimmy's company for $100, he would only have $100 at the end and wouldn't have made any money.
Discount Rate
This is what brings in the last part which is what Wall Street call a discount rate. This is how much you discount the total profit of a company back to today. Going back to Jimmy's company, using a discount rate of 5%, the value would be $82.27. Why? Investing $82.27 at 5% for 4 years would equal exactly $100. If we used a 10% discount rate, the value would be $68.30. This is where the subjectivity comes in. Let's say Jimmy offered John the company for $75. If John thought that he could invest his $75 in the s and p 500 with a return of 10% annually, then he should turn down the deal as he could do better. If he thought he could only get 5% with bonds or didn't think the s&p 500 or any other investment could do better than 5%, then he should buy Jimmy's company for $75.
Art of Investing
The discount rate is one subjective part of the investment decision. The other and significantly more important part of the investment decision is how much the company will make over time. In Jimmy and John's story we knew exactly that the company would only be alive for their four years in high school and we knew exactly how much money they would make in those four years. We have know idea how many years or how much money Amazon or Apple will make over their total existence. This is where the art of investing comes in. Good luck