So, how much should you pay for stocks? Should you just buy them at market prices? When buying stocks, do you just get that gut feeling that this stock would be the key to growing your money?
Yes. And no. Instinct is necessary, and the volatility of the market cannot be accurately measured. If there’s an exact science to it, then practically everyone would be investing in stocks. So it takes a calculated, intelligent bet. As I’ve said, it will be calculated, the risk would be minimized, people with PhDs will be talking all about it, but at the end of the day, it will still be a bet, a risk that you will be taking. A company that is doing so well can suddenly go bankrupt the next day. The probability of that happening is the probability that the stock you’ll be investing your money now will be worthless tomorrow – so it is rare. It rarely happens, but it does.
So how do you minimize your risks? How do you know how much the stocks really are? How much you should be paying for them? Are the stocks overvalued? Undervalued? Or just right?
There are pricing models that are used to set an expected price for stocks. If the actual price is equal or near the calculated price, then chances are you are advised to “hold” on the stock buying. Now, if the actual price is higher than the calculated price, then you should “sell”, and if the actual price is lower, then “buy”.
It is getting the calculated price – your expected price – that we will be discussing now.
1. Future dividends
A simple formula will be taking the dividends that the company is paying out. If XXX Company usually pays $1 per year and you expect them to do so for an indefinite time, then you just have to divide $1 by the total interest rate*. So at 8% interest rate, you expect the stock to be at $12.5. If the stock’s price is $15, then you sell the stock. If the stock’s selling at $5, then buy them, since you are buying something that you believe is worth $12.5 at merely $5.
*I’ll be discussing the concept of the interest rate in another article.
But how many companies pay out a fixed dividend per year? If a company is doing well, chances are these dividends will increase. Hence the next pricing model:
2. Gordon growth model
It is like the previous model, with a new variable – growth. The formula is now
|Expected dividend a year from now||
|Interest rate – growth rate||
i – g
You can get the growth rate by obtaining the dividends from the past years (around three or five) and getting the average.
The third model is a more complicated one, and will be discussed in the next article.