Valuation

I'd pay any price just to get you
I'd work all my life and I will
To win you I'd stand naked, stoned, and stabbed
I'd call that a bargain
The best I've ever had
--The Who

This morning Intel Corp stock (INTC) is trading at about $45/share. Is that an attractive price? At what price would INTC be a good buy? These questions relate to valuation. Valuation is the process of determining how much a security (or any financial asset for that matter) is worth.

Valuation is important because, to be a successful investor, you need to have an idea of what price represents good value for securities that you're interested in. To achieve high returns on investment (a.k.a. ROI), you want your outlays to be low and the cash you get back from your investments to be high. Overpaying for securities reduces your ROI.

A security can be viewed as a money machine with capacity to dispense cash. Some money machines spit out cash at regular intervals; other machines surrender cash sporadically.

The theoretical problem of valuation involves estimating the size and timing of all those future cash flows from the money machine, and then discounting them back to the present to estimate the 'net present value' of all those distributions. That net present value is what the security is worth today.

The essential valuation question is: how much should I pay today for all of those future cash flows?

If that sounds complicated and inexact, well, it is. One problem that you can probably sense involves peering into the future to predict those future cash flows. The future is uncertain. That uncertainty means forecasts are wrought with error. Moreover, the farther out into the future that you gaze, the more error prone your forecast becomes.

Although volumes have been written about valuation theory, it turns out that valuation in practice is often more art than science. To make things more practical, investors have developed various shortcuts and rules of thumb to estimate the 'fair value' of securities. We'll discuss several of these in posts to come.

Meanwhile, when studying stocks or other securities, get into the habit of asking valuation-oriented questions. What is the 'fair value' of that stock? At what price would that security be a bargain?

This habit will serve you well.

position in INTC