Before we move forward, lets discuss the time value of money. This concept is at the core of financial valuations. It states that a $100 today is worth more than $100 a year from now. Why? You can put your $100 in a bank it will be $105 next year. That's the time value of money. In other words, there is an opportunity cost involved.
Back to our stock now. We've determined the return that we are expecting from the stock. And we have the price of the stock as it trades in the market. We can use the two to determine what should the price one year from now. If price is $10 and expected return is 10%, then price of stock 1 year from now is 10*(1+10%) = 10*1.1 = $11. In other words, if the stock price is $11, one year from now, you can pay $10 to buy it today.
A little digression to understand where a stock's value comes from. A company makes and sells products and earns revenue. Out of this, go expenses such as raw materials, salaries etc. If the company has any debt, it needs to pay interest on that. And what remains is the profit. Of course profits are taxed, so a portion of that goes to the govt. What remains after all these is called Profit After Tax (PAT) or Net Income (NI) is available for distribution among shareholders. In reality, of course, companies "reinvest" PAT, meaning they will use this money to fund further expansion and generate more revenues etc. For simplicity, lets say a company is "mature", meaning there are no opportunities of growth. It will just keep making and selling the exact # of units year after year. As a result, all PAT will be distributed as dividends to shareholders that is you and me:) In reality though PAT doesnt equal CASH - that's accounting for you, which is way out of the scope of this article. But understand that some adjustments are made to PAT to arrive at "Cash Flows (CF)".
Now it all comes together. Once you know the CFs of a company year after year, you can discount them all by the expected return rate to get today's value. But we only have data to calculate last year's CF. How do you know what the company makes in future years? This is where assumptions and projections come in. You look at the economy, industry etc., and predict that revenues, expenses will grow or shrink at a certain rate leaving you with a CF. This is one reason why analysts may have differing opinions about a stock's value - because they have different growth assumptions. Once you buy a share of a company, you own it forever (or until the co shuts down). So you'd have to project CFs out to infinity. To make it mathematically manageable, you project it out 10 years or so, and use a geometric series formula to find the value at the end of 10 years. Now discount all these values to today and you have the value of the firm.
Now, if the firm has taken any debt, that will need to be repaid eventually. So subtract debt from the value of the firm and you have the "equity value" of the firm, which is what shareholders own. Simply, divide the equity value by the number of shares outstanding, and voila! you get value per share.
If this value is less than market price, the stock is overvalued. If it is greater than price, the stock is undervalued.
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