Recently, I read a book, A Random Walk Down Wall Street by Burton G. Malkiel. In the book, he discussed two ways to valuate a stock – The firm-foundation theory and the castle-in-the-air theory.
The firm-foundation theory assumes that each stock has a true value which is equal to the present value of all its future dividends. It is likely that you have heard something similar because this approach is somewhat similar to Warren Buffett’s style of “buying securities whose prices are below the true value, and selling those with prices are above the true value”.
Of course, the challenge is in determining the true value, which can be broken down into two parts.
1) Forecasting of future dividends of that stock, and
2) Estimating the (current and future) market interest rate.
The castle-in-the-air theory is also known as the “greater fool” theory. It does not matter how much you pay for any stock as long as you are able to find a “greater fool” who is willing to pay more for it. A story mentioned in the book is that stock investment is like entering a newspaper beauty-judging contest where one must vote for the prettiest face out of a hundred photos, and the prettiest face is determined by the largest number of votes. It is basically saying that the true value of a stock does not matter as much as its perceived value by investors.
The way I translate these two theories to practical strategies to support my stock-buying decisions is as follows:
1) I favor stocks that are likely to have good future dividends (I will forecast this using a simple approach until I find better and more reliable approaches).
2) I try to avoid being the “greater fool” by shunning all stocks with high P/E (using STI’s P/E as a gauge).