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What are your shares really worth ?

By Roger Montgomery

In the “Invest, don’t speculate” article, I outlined the steps to navigate the stock market’s inexplicable rises and falls. Simply buy great businesses at prices below their intrinsic value and hang on to them as long as they remain  both great and cheap. The question I receive most is, how do I calculate the true value of the best stocks ?

The price of a share is not its value. Price is what you pay, and value is what you receive. Your job is to buy when shares are below value and to do that you need to know the true value.

Imagine a $1 million bank account that pays out 20% annually and I put it to auction. You can be certain someone will pay more that $1 million for it. Many will correctly appraise the risk is low, and be happy with, for example, a 10% return. In simple terms, an investor happy with half the returns produced can pay twice the balance of the bank account, or $2 million. This is the intrinsic value of the account. If you can buy it for less, you will do well.

It’s the same with shares. The bank balance is the equity on the balance sheet (Equity) and the return is known as return on equity (ROE). The return you seek is called the required return (RR) and the basic formula is :

Intrinsic Value = ROE / RR x Equity

So lets now apply this valuation formula to a real world example.

Telstra has over a million shareholders, many of whom are unhappy because in May the shares closed at an all time low. Ten years ago Telstra’s share price was $9.20, but more recently, just $2.88. Using ROE/RR x Equity, Telstra was worth only $4.12 in 2000 even though the shares were at $9.20.

Many people bought Telstra at $9.00 believing it would go higher. But with my valuation formula, you wouldn’t have. Over the long run, the stock market is a weighing machine and price follows true value. Today (July 2010), the price is about $3.05, so even though the shares have fallen 70% over a decade, they are no bargain.

By understanding what shares are really worth, you can make sense of the share market.

Roger Montgomery shares his step-by-step guide to valuing the best stocks and buying them for less than they're worth in his new book, Value.able, available exclusively at www.rogermontgomery.com. Roger also shares his stock market insights at this blog http://blog.rogermontgomery.com

Investors should obtain relevant and specific professional advice before making any investment decision. The information contained herein does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision investors should consider, with or without the assistance of a licensed advisor, whether the information contained herein is appropriate in light of their particular investment needs, objectives and financial circumstances.

The articles herein contain the current opinions of the author only. The author’s opinions are subject to change without notice. This article is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of the author.