A common misconception among newer investors is that a higher stock price means a company is also more expensive or worth more. Take, for example, Booking. Booking's stock price is at $1'703. Microsoft's stock price, in comparison, is only $210 (as of July 2020). Which company is worth more?
While Booking has 0.04 billion shares outstanding, Microsoft has 7.58 billion shares outstanding. To calculate what a company is currently worth on the market, the number of shares outstanding is multiplied with the current share price (= market capitalization).
Booking: $1'703 x 0.04 = $68 billion
Microsoft: $210 x 7.58 = $1'592 billion
Initially, it looks like Booking is worth much more than Microsoft because its share price is much higher. However, Booking has issued a lot less shares compared to Microsoft. And in fact, Microsoft is currently worth about 23 times more than Booking on the market.
But what is the actual value of a company? What we just calculated is the current market valuation of a company. As investors, we want to identify companies that have an intrinsic value that is higher compared to its current market value.
"Price is what you pay, value is what you get."Warren Buffett
A common measure to get a first idea of a company's value is the Price/Earnings-ratio (P/E-ratio). It is calculated by dividing the share price by the earnings per share (or: market cap / net income). The P/E-ratio tells an investors how many years it would take the company to earn his/her investment assuming stable profits. If, for example, company x had a P/E-ratio of 10, it would take ten years for the company to earn what you put in (100 % return). However, earnings are very volatile and can be manipulated by different accounting practices.
"Profits are an opinion, cash is a fact."Alfred Rappaport
Many professional investors mostly care about cash. Like Alfred Rappaport's quote says, cash is a fact. Therefore, investors should calculate a company's free cash flow (FCF). FCF is the amount of cash generated by a business that is available for distribution to e.g. its shareholders. The current FCF-yield can be calculated by taking the FCF and dividing it by the market cap.
Discounting future cashflows
So far, we have only looked at value from a present perspective. Value however is for the most part derived from a company's ability to generate FCFs in the future. As a consequence, many investors try to predict how well a business is positioned for the future. Does the company operate in a future market that is growing? Does the company have a competitive advantage / superior technology? Based on these prospects, they develop estimates for the future FCFs.
"A bird in the hand is worth two in the bush."
As the proverb suggests, it is better to have cash now than tomorrow. This means you have to discount the future FCFs. If you expect an annual return of 10 % for example, you could discount the future FCFs at a rate of 10 %. This method is called discounted cashflow model (DCF). DCF will provide you with a "fair value" of a company based on your assumptions.
As predicting the future is a rather difficult business, future assumptions often turn out to be wrong. Legendary investors like Warren Buffett therefore use the principle of a margin of safety that was developed by Benjamin Graham. Investors should substract e.g. 30-50 % from the DCF-value to compensate for errorous assumptions. This way, even if your predictions where not fully correct, the investment might still return a good profit.
To sum it up
Valuing a company is not an exact science. While the efficient market hypothesis suggests that all securities are always perfectly valued given the information that is publicly available, fundamental investors disagree. They believe through thorough analysis and critical thinking investors can find stocks that are underappreciated by the market. For further information on this topic, you can find book recommendations on valuing a company in our book list.