One of the stock investing terms that you are likely to hear regularly is "valuation." Stock valuation is something that many investors look at when deciding what investments to make. Simply put, stock valuation is a measure of how much a stock is worth. A lot of the time, stock valuation is done in comparison to price. It is important to note that stock valuation and price are not necessarily the same thing.
Valuation v. price
Just because a stock has a certain price, does not mean that it is worth that much. The efficient market theory of valuation does posit that if a stock exchange trades at a high volume, and is organized well, the price will closely mirror the valuation. But this is not always true. Sometimes price is too high (over valued or undersold) or too low (under valued or oversold) for the true value of a stock.
There are psychological factors at play as well. As you know, the current economic climate makes it very difficult to predict the stock market. And swings in price are common as investors gain confidence or lose confidence in a stock or a sector. Indeed, these times can make it very hard for stock price to adhere closely to valuation.
Discounted cash flow theory of stock valuation
The most widely accepted theory of stock valuation (and there are many) is that of discounted cash flow. Discounted cash flow takes into account the issues of risk and other possible issues on future earnings. Discounted cash flow insists that there should be an accounting made for the time value of money, and it takes away risk from the value. This allows the investor to get a more accurate view of how much a stock is worth.
Buying stocks with good valuation
It is best practice to buy stocks with good valuation. This means that you want to invest in stocks that have a valuation that is close to the stock price. It is best if you can get a stock that is under valued. That way you will get it at a good price. And when the price finally catches up with the valuation, you will find that you have made a tidy profit.
Disclaimer: I am not an investment professional. This should not be construed as investment advice. All investment carries the risk of loss. Before investing, do your own research and/or consult with an investment professional.
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