How to value stocks and shares

How you can value any security

Melanie

The second part of our Value Investing Series shows how you can value any security - if you know how much it will pay, when it will pay it and the return you want to make.

Last issue we looked at value in the context of the ancient people of north Queensland, whose stone axes and stingray barbs possessed real value in terms of what they could actually be used to do. So a complex system of barter developed incorporating these and a host of other commodities.

In those days everything was relative, but now we have hard (or at least hardish) currency against which to measure everything. With the help of money, anything that can be traded can be ascribed a value in monetary terms. And although some things can't be bought (as Paul McCartney famously explained about love), rights and obligations feature large on the list of tradeable items - which is where shares and other securities come in.

Financial securities, including shares, are little bundles of legal rights and obligations. Most importantly, they confer the right to receive money in the future. But this is where things get a bit complicated because the value of an amount of money depends on when you receive it.

Time value of money

The principle is known as the 'time value of money' and we can flesh it out with an example. We'll assume that all money earns interest at 8% a year and costs the same to borrow. On that basis, if I have $100 now, what will it be worth in 10 years' time?

The answer is: 100 x 1.0810 = $215.89. Now, if someone offered you $215.89 in 10 years' time, how much would you pay them now for it? The answer goes like this. The money you pay now is either money that won't be earning interest for you at 8% a year for the next 10 years, or it's money that you've borrowed and on which you must pay interest at 8% for the next 10 years. Either way, paying out money now costs you 8% a year until you get it back. So, to buy a cash flow of $215.89 in 10 years' time, you'd pay up to $100 because, if you'd kept the $100 (or not borrowed it), you'd have turned it into $215.89 over 10 years (or saved yourself that amount).

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