When you're looking at a stock, it's important you know what price you should pay.

Every day the NZX goes live and you can buy some of New Zealand's biggest companies at a price the market dictates.

But how do you know if the market is offering a good price?

For example, if shares of Skycity are selling for $2.50, is that worth it?

Or should you wait until they fall to $2?

Or are they actually worth $5, so $2.50 is a bargain?

Obviously, you can't just guess.

Luckily, there's a way for us to find out, and it's reasonably simple (you actually learn all the maths you need for it in high school).

It's just that when we talk about stocks, people tend to get flustered. 

So let's talk about something we all understand.

Let's talk about a simple term deposit at a bank, like ASB.

Say we have just opened a term deposit of $1,000, that pays 5% interest per year, for 5 years.

The great thing about this investment is the cash flows are perfectly predictable.

We know we're going to receive $50 each year (assuming we don't reinvest our interest).

This makes this investment is extremely easy to value.

But $50 today is not the same as $50 tomorrow!

Before we can value it, we have to make one adjustment.

We have to take into account the time it takes for us to get each $50.

This is because receiving $50 today is not worth the same as receiving $50 next year.

Obviously, the $50 we receive right now is more valuable to us than the $50 we need to wait for!

Why?

Because if I received $50 today, I could put it in a savings account, and even at a 2% interest rate, I would have $51 after waiting a year.

This means receiving money now will always be worth more than receiving money some time in the future.

To account for this, we do something known as discounting.

We ask - how much is $50 received five years from now worth to me today?

To do that, we need a discount rate. 

We've locked in our term deposit at 5% per year, but let's assume the average interest rate over the next five years is going to be 3%. That's our discount rate.

That means we will discount that $50 by 3% for five years.

If we run those numbers, we will see that $50 received five years from now has a present value of $43.10.

This means receiving $50 in five years is worth $43.10 to me today.

Or to put in simpler terms - receiving $43.10 today and receiving $50 in five years is the exact same thing.

So how much is the term deposit worth?

Now that we understand discounting, we can work out the true value of that term deposit.

We simply need to discount each of those $50 cashflows over the next five years, then add up their present value.

Again we'll assume the average interest rate over the next five years is going to be 3%.

Using the same formula I showed you above (I won't bore you with the calculations), I can work out the present value of all the future cashflows is $1,091.60

This means if I had just opened a $1,000 term deposit with a fixed 5% interest rate for 5 years, technically I should be able to sell that term deposit to a rational investor for $1,091.60.

Why is it worth more than $1,000?

Because the current interest rate is 3%, but my term deposit has an interest rate of 5%. 

This means a rational investor would be willing to pay more than $1,000 for my term deposit.

He knows if he puts his $1,000 into the bank he will get 3%, so he should be willing to pay a little extra to get a term deposit paying 5%.

Now we finally get to the good part.

We can do the same thing with stocks!

If we know the bank is going to pay us 3% per year, but a stock is likely to pay us 8% per year, we can now use discounting to work out exactly how much we should pay for that stock.

The great thing is - on the stock market, prices change every day, and sometimes for no good reason.

This means we might find a stock that we think we should be worth $1, but it might be selling for 60 cents!

This is how people make outsized returns in the stock market.'

How Do You Value A Stock?

The maths for valuing a stock is exactly the same as the maths for valuing a term deposit like we did above.

We take all the expected future cash flows the company is expected to make, then discount them to today, and that will give us a "present value".

Note that when dealing with stocks, we want to value the actual company. This means we're not valuing the cashflows expected to come to us (the dividend), but the cashflows that the company itself is expected to generate.

For example, if we think Skycity is expected to generate $50 million in cashflows every year for the next 10 years, we can discount all those cashflows, which will give us a figure of what the company is worth.

Here's where things get tricky:

Obviously, we can't be certain what cashflows Skycity will generate over the next ten years.

We can only make educated estimates based on - their future plans, their forecasts, our understanding of the casino and hospitality industry, what we think their CEO is capable of, what's happening in the economy, their past results, and so on.

Unlike the term deposit, where we know exactly what the cashflow will be, with Skycity, we have to make guesses.

This means we can never come up with a "true" value of the company, because it's all based on assumptions.

This is also one of the reasons great investors like Warren Buffett always give the same advice - invest in companies you understand, and that are predictable, because they are easier to value than flashy companies who are changing every year.

A Valuation Example: SkyCity

Keep in mind this is NOT a real valuation - it's going to be very rough and probably not accurate at all, but it should give you a good example of the process.

According to Simply Wall Street, Skycity generated $141 million in free cash flow over the past year. 

So what do we do with this figure?

We'll assume that Skycity will generate that same amount of cashflow every year for the next 10 years.

Then we need to discount those cashflows, like we did with our term deposit example.

Right now, we can get 5% at a savings account at any NZ bank. 

Obviously stocks are more risky, so we should want to earn more than 5% if we're investing in stocks. Let's give ourselves a discount rate of 10% (in other words, we want our investment to return at least 10% per year).

Now we need to work out the present value of all those cashflows, using the formula from earlier.

Thankfully, since I spend so much time looking at stocks, I have a pre-made calculator you're welcome to use.

Don't be intimidated by the numbers. There are only two numbers you really need to look at which are circled in green.

• Free cash flow
• Discount rate (your acceptable rate of return).

Based on these numbers - ($141 million per year in cash flow, discounted at 10%), we can see SkyCity would be worth $1.46 per share.

If you scroll further down to the calculator's workings, you can see each year being discounted and what the present value of the cash flows each year are:

To get a "value per share" you will need to add in some othe data, such as the amount of cash the company is holding, how much debt they have, and how many shares are on issue, plus the current share price.

These can all be found reasonably easily on any free stock website. I cover all of this and more in my course Simple Stocks.

So our final result is - Skycity is worth $1.46 per share.

The current share price is $2.42.

Meaning based on this calculation, the shares are about 66% too expensive, and I would NOT be a buyer of Skycity.

Again - don't consider this an accurate valuation of Skycity.

First of all - I don't expect them to cashflow $141 million every year for the next 10 years. They've had very inconsistent cashflows.

Second, I don't consider Skycity a "high-risk" stock - they're a monopoly and own a lot of high value real estate, so I probably wouldn't require a 10% discount rate.

Thirdly - I haven't even looked at their management team, their future plans, or have any understanding of the gaming industry, and a dozen other things I would want to look at before investing.

As we said earlier, valuing a stock is difficult, because nothing is perfectly predictable like it was with a term deposit.

However, perhaps you do find a company that has very predictable cashflows, trading at a bargain valuation. Or perhaps you have specialised knowledge on a company or industry that will help you predict cashflows better than the average investor. There are countless things that can give you an edge, and that's when knowledge on how to value stocks becomes very valuable.

Happy investing!

This article is an extract from one of my lessons in my course Simple Stocks. If you're interested in learning more about stocks and building a stock portfolio of your own, there's no better place to start! Learn more about my course Simple Stocks by clicking here.