Indian Ticker : Choose Right Stocks that Ticks Money

Secret #7: Calculate how much money you will make, not whether the stock is undervalued or overvalued according to some academic model.

As an investor what is the right question to ask? Most ask whether the stock is undervalued or overvalued. The problem with this is that there is no way of properly determining whether a stock is, in fact, undervalued or overvalued.

There are various academic models for calculating what is called the intrinsic value of a stock. From my extensive experience as a research mathematician all these models, referred to as discount cash flow models, are fatally flawed. There are four areas that bring them down. They are theoretical, contradictory, unstable and untestable.

These problems are a rather technical to explain fully so I will only give the general ideas behind them. Just because some theoretical formula labels a stock as undervalued does not mean that you are going to make money from it.

For example, perhaps the price will stay at that level. The models are contradictory since different values are obtained depending on which of the many variations of the models that you use.

They are unstable since insignificantly small changes in the input variables lead to changes of 100 percent or more in the intrinsic value. This means that in instead of the models being objective, they can lead to almost any output that is desired. And finally the models are impractical because they are untestable.

Some of the input variables require verification over an infinite number of years. For example, forecasts of growth rates have to be made over not just five or ten years, but extending out forever.

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