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  • Writer's pictureIshfaaq Peerally

How to Value Stocks

It is very easy to find the intrinsic value of bonds. There are formulas that we can use for that. But what about stocks? There's no specific formula since all stocks are different. But what if we looked at stocks as if they were bonds. This is what Warren Buffett $BRK.B uses.

A bond is a debt obligation. Governments $TLT and corporations $HYG $LQD will issue bonds to fund projects. Any bond as a par value, a coupon rate and a maturity date. Based on these three numbers and also on the discount rate of that bond, we can find its intrinsic value or present value. The discount rate of the bond is obtained by looking at similar bonds and their yield and we need to use it because money today has more value than money in the future.

What about stocks? We can look at stocks as if they were bonds. Instead of a coupon payment, a stock will have owner's earnings. Stocks do not have a maturity date and, therefore, we will use a terminal value. To find the discount rate for stocks, you need to compare it with the risk free rate, that is, the yield of 10-year US treasury bonds. If you're investing in stocks, you're looking for higher returns than the 10 year rate since you're taking more risk. You also need to use a discount rate higher than your best investment for the same risk. It makes no sense investing in a new company if you already have one in your portfolio giving you the required rate of return for the same risk.

It may look complicated and it has to be, otherwise, everybody would be as rich as Warren Buffett. But once you understand how it works, you will get used to it. The best way to learn how to value stocks is to actually practice it.

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