Chapter 4: Stock Valuation

In this Chapter, we will introduce how to evaluate a stock based on its future cash flows (dividends).

Admittedly, how to find the correct value of the stock is the Holy Grail of the financial world. Because once you know the true value of the stock, you basically find the money printing machine. Therefore, the method introduced in this chapter is nothing more than a model (it is actually often called the firm foundation theory). If you solely count this method to be a billionaire, the chance for you to make it is very, very slight.

However, that doesn't mean you can ignore this ideal model. On the contrary, you should really ace it. The reason is pretty simple — it is the ABC of the financial context. This model, whether or not reflecting 100% of the real world, is used everyday by everyone working in the field of finance. You may choose not to believe it, but you can't afford not knowing it.

The Firm Foundation Theory

The Firm Foundation theory basically considers every asset should have a "intrinsic" value and the price fluctuate above and below it.

In The Theory of Investment Values, John B. Williams suggests that the intrinsic value of stock is the present value of all its future dividends. However, the reality may be more difficult than it sounds. In his famous book, the random walk down wall street, Burton Malkiel says:

"(T)he firm-foundation theory relies on some tricky forecast of of extent and duration of future growth. The foundation of intrinsic value may thus be less dependable than is claimed."

As every theory, there is supporting and contradicting evidence from the real market for the firm foundation theory. To give it a final ruling is beyond the scope of this course (and perhaps every finance textbook). It is smart to understand it first, and maybe test it yourself later in the real market. Afterall, you could be the next Warren Buffett, who made his fortune allegedly following the firm fundamental theory.

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