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Have you ever heard the old adage about knowing the price of everything, but the value of nothing? If you want, you can be flooded with nearly instantaneous data on the prices of literally thousands of stocks, or the composite prices of numerous indexes. However, information on what might be the actual value of any of these stocks or indexes is a different matter altogether. That's where things get murky. Stock market valuation using the net-present-value method gives the planner and client a sensible framework upon which to make investment projections and assessmentsand understand them.
That's not to say there aren't some well-known gauges of stock and stock index valuation. Among the most popular are the price-to- earnings ratio (P/E), dividend yields, the ratio of price to cash flow, and the value of underlying assets (or book value). The often quoted price-to-earnings ratio is a particularly awkward method of valuing stocks either individually or as an index. It was originally conceived of to give an idea of valuation by indicating how many years it would take a company's current earnings to cumulatively equal the level of its current price. However, dividing price by earnings has some real problems associated with it. If a stock has zero earnings, then the P/E is infinite. If a company is losing money, it will have a negative P/E. If it's losing only a little money, it will have a discomfortingly large negative P/E, but if it's losing a great deal of money, it will have an ironically small, negative P/E. Price-to-earnings ratios are by their very nature oriented only toward stocks that are making a profit, and stocks that aren't making money normally show no P/E in the common sources of stock market data. Does that imply that only stocks that are making money in their current reporting period are worth anything?
The other common gauges of stock valuation have their own drawbacks. Dividend yield indicates the rate by which cash is returned to the investor. However, many companies prefer to reinvest their profits vs. distributing them. Also, distributing profits frequently creates a tax event for investors. Many of the best companies around, with the highest earnings growth rates and the best overall prospects for making investors the...