Some inherent problems with these methods.

Some inherent problems with these methods.

DCF:  Treat this with extreme caution.  The danger is that you will give it more weight than it deserves because it is been spat out by your elegant spreadsheet.  Remember John Maynard Keynes - it's better to be vaguely right than precisely wrong.  Your time will be better spent thinking about your assumptions and why they[re so different from the market's.


Price/BV:  All things being equal, a good business making high returns on capital will justify a price that's higher than its net asset value - particularly if it has ample scope to invest further capital at those high rates of return.  And a poor business making low returns will deserve to be priced at a discount to its net asset value - particularly if it's determined to keep investing capital at those low rates of return rather than return it to shareholders.  There's a broad correlation between price-to-book ratio and return on capital, though it's far from perfect, reflecting the problems inherent in these measures and the market's own inefficiencies.  So, if you find a company making decent returns on capital, but priced around book value or lower, it might pay to wonder why.  Generally there's a reason - such as that those returns are flattered because the balance sheet undervalues the company's capital or the returns are likely to take a tumble - but occasionally it might suggest a bargain.

Graham's net current asset approach:  When a common stock sells persistently below its liquidating value, then either the price is too low or the company should be liquidated.  If it is worth more as a going concern, then the stock should sell for more than its liquidating value.  These types of opportunities have become scarce.


PE ratio:  You can approach this by assuming that a stock is worth a multiple of this year's earnings, where the multiple is one divided by YOUR target rate of return.  So, if you are targeting a return of 8% a year, then you could, in theory, pay a PER of 12.5 (1 divided by 8%).  And if you were targeting 12% a year, then you'd pay a PER of up to 8.33.  And if a stock were priced in the market on a PER of 16, then theoretically, it would be set to provide a return of 6.25% (1 divided by 16; this is also known as its 'earnings yield').  But, in practice, things aren't so simple.  Some companies persistently make better than average returns on their capital, while others make poor returns.