There are two types of participants in the stock market. Investors buy stocks for the long term and plan on profiting from dividends and an increase in the stock's price. Traders are interested in profiting on short-term changes in price.
The difference in these two approaches is reflected in whether a stock primarily gains in price because of increased value to the stockholder or because traders believe they can find someone else willing to buy at a higher price.
There is nothing fundamentally wrong with either one of these approaches, however for most investors price changes driven by speculation can distort the apparent value of the stock.
Here's what happens when speculators become active with a stock. Assuming the speculators are bidding up the price of the stock, the price earnings ratio (P/E) will increase even if earnings remain the same. The same happens although in the opposite direction when speculators sell off a stock.
Remember the P/E formula is the stock price divided by earnings per share. With flat earnings a higher price means investors are willing to spend more for the company's earnings. If the price is much higher than the intrinsic value of the stock, it becomes overpriced and endanger of collapsing.
If a long-term investor has been holding the stock for some time, she may decide this is a great time to sell. However if a long-term investor is looking at the stock as a candidate, a high P/E will be a warning flag that now is not the time to buy the stock.
The key to this process from a long-term investor's point of view is knowing what the intrinsic value of the stock is and comparing that to the price available on the market. Without knowing the stock's fair market value, it would be difficult to know how to move on the stock.
For the long-term investor the most important number is intrinsic value of the stock. With this number in hand a long-term investor is prepared to decide if the stock is a good buy or not. Likewise, the investor who has been the stock for some time, the intrinsic value will tell her whether this is the time to sell or not.
The P/E does not tell you the intrinsic value of the stock, but if you compare the candidate stock to similar companies in the same industry, you may get a good idea of whether the stock is overpriced or underpriced.
Discounted cash flow is the accepted method of calculating intrinsic value. It uses discounted cash flows to arrive at a stock price that reflects the present value of its future cash flows.
The discounted cash flow model is built on the premise that a dollar today is worth more than a dollar next year. By estimating future cash flows and discounting them back to present value investors can arrive at a price that reflects the value of the company to stockholders.
If this value is significantly less than the current market price for the stock, it may be a good candidate for long-term investor. This method of investing requires patience to wait for prices that allow room to profit from the stock's growth.
Determining the intrinsic value of the stock is a complicated process that involves making projections about revenue growth, cash flows and other important metrics. Very few of us are qualified to make an accurate position prediction about the companies future growth in revenue or cash flow's.
Fortunately, much of this information is available on Yahoo Finance or Morningstar. Both of these websites feature detailed information about companies and offer projections on future growth in revenue and cash flows.
Armed with that information, long-term investors can find discounted cash flow calculators that can make the complicated calculations.