The short answer is discounted present value of future earnings (profits). You can do that in two formulas within a spreadsheet… However, let’s understand it from a basic pretend stock.
Acme Widgets earns $5 per share per year. They have earned $5 per share for the past 5 years and are expecting $5 per share for the next 5 years. So we expect $5 per share for the foreseeable future.
What share price makes sense? Let’s say you want to earn at least 5% on your money. The formula is 5/sp = .05. You can take my word (if you must) that sp = 100. So generally we wouldn’t want to pay over $100 for a share of Acme Widgets.
We do something similar if Acme Widgets is expecting to grow it’s profit by 25% per year in the next 5 years. Calculate future value in your spreadsheet… Your contribution is $5 per year, for 5 years, at 25% interest (since it is growing 25%). Then take your future value and calculate net present value using 5% as your rate, 5 periods, and future value that you calculated (make sure to add the share price you expect to sell at).
My results: Future value = 41.04, discounted net present value $110.50. Note that I added $100 as my price to sell at, which is probably less that it would be.
So for this example, we do not want to pay over $110.50.
You probably also want to discount this price for your perceived risk.
I promise that this is the worst math I will talk about.
This really doesn’t answer whether or not you would want to buy the stock… I can give you some rules of thumb to look for:
1. Current ratio > 1. Current ratio is how much cash or other short-term assets the company has compared to its near-term liabilities or obligations. A value of 1 or greater means it can currently pay all of its bills with the cash it has.
2. Profit growth over a few years
3. Return on equity > 20%
4. No debt
5. A product that is difficult for other companies to compete against.
6. Future projections of profit growth
7. Good management team that values shareholders
These are just rules of thumb. There are reasons to break them but no reasons not to know this information.
Note that it may be difficult to come up with all of the info you need right away. That’s ok. Put the company on your watch list and read its news and quarterly reports before you buy.
Note that this article, as it is, was posted to my personal Facebook page on March 26.