Investors often erroneously assume that a great company translates into a great investment. We discussed several ways to identify superior businesses, but we did not bring up valuation. Finding strong companies is crucial in the investment process, but it is equally important to determine what those companies' stocks are actually worth. Your goal as an investor should be to find wonderful businesses, and invest in them at reasonable prices. If you avoid confusing a great company with a great investment, you will already be ahead of many of your investing peers. 

Suppose you are buying a car. Before you make a purchase, you will probably want to do some research, identify a few promising candidates, and take each for a test-drive. But throughout the process, you will also be aware of price. After all, you would not pay $50,000 for a used clunker, though you might pay that much for a new luxury car. Likewise, you would probably never spend $200,000 on a car, no matter the make.

The same thing should be true if you are thinking about buying a stock. A company's profitability, growth prospects, quality of management, and competitive advantages vis-a-vis its rivals are all important factors to consider. However, even the greatest company in the world might not be an attractive investment if its stock is priced too high. The price you pay for a stock can have a significant effect on your returns, and it can mean the difference between a good investment and a mediocre one. (Or worse!)

Why Valuation Matters

To illustrate the importance of valuation, consider the case of hypothetical investors Smith and Johnson. Johnson is a value-conscious investor who always keeps on eye on valuations, even though he loves a great growth story. On the other hand, Smith also loves a growth story, but he buys whatever is hot, regardless of valuation.

On Jan. 2, 2009, Johnson bought 100 shares of Netflix (NFLX) for $30 (not much higher than where it traded four years prior), a P/E of about 28. At the time, the future of the stock was less certain, and its potential subscriber growth was arguably not priced into its shares.

As the firm's business model took off, so did the shares in 2010. Netflix become one of the hottest stocks that year, rising 218% on top of a healthy 84% increase in 2009. However, by early 2011, the stock started to look a overheated to Johnson. Sure, the company's results were still impressive, but the shares continued to skyrocket over $200. Although Johnson raised his expectations for the shares, he concluded that at $200, the firm looked more than twice as expense as it should have. He sold his stake in March 2011 for about $200 a share--an exceptional return on his original $30 investment. The stock went on to reach new highs close to $300, but Johnson didn't look back, because he knew the market price was not based on company fundamentals, but rather investor excitement and unrealistic expectations.

On the other hand, Smith didn't care about Netflix until the company really started to impress. He bought 100 shares in December 2010 (a few months before Smith sold his shares) for $197, after the stock had already established its march upward and had a trailing P/E of about 60. That's pricey by nearly any measure, but Smith didn't care. He was excited about the stock's possibility and willing to pay any price for it.

In retrospect, we can see that Smith was buying near the peak of a stock bubble that was just about to burst. After reaching a high in July 2011, the stock took a swift downturn as results began to disappoint, the company faced intensifed pressure from Amazon (AMZN), and consumers began to increasingly adopt digital streaming, where Netflix had less competitive advantages. The firm's botched business plan involving a split of its DVD and digital-streaming business didn't help matters, either. By November 2012, the stock had retreated to $80 per share.

With 20/20 hindsight, it's easy to see that Netflix was more reasonably valued in 2009 and terribly expensive in 2011. In the real world of investing, we don't have the benefit of knowing exactly what is going to happen, but we can still make our best estimate as to whether a stock is cheap, reasonably priced, or too expensive. Making such estimates is arguably the most important determination of your investment success. In the next several lessons we'll introduce you to some of the ways you could try to determine what a stock is worth.

Measuring Market Capitalization

The first step to figuring out whether a stock is cheap or expensive is measuring the market value of a company. Unfortunately, the stock price you see in the newspaper or on your computer screen doesn't say anything about how much a stock is really worth. A $100 stock is not necessarily more expensive than a $10 stock, and it may be in fact cheaper.

The most common way of measuring a company's value is market capitalization, or market cap for short. (To recap, the market cap of a company is the total market value of all the company's outstanding stock, representing the share price multiplied by the number of shares outstanding.)

Market Cap = (Number of Shares Outstanding) x (Price of Each Share)

Keeping the number of shares constant, a company's market cap will rise and fall with its share price. The market cap also represents the value the market places on the entire company. The companies with the largest market caps are all big, well-known names and by definition are among the most widely held stocks.

It's worth noting that market cap measures only the market value of a company's equity, and you may remember that companies have access to two sources of capital: equity and debt.

To get around this, investors commonly use a variant of market cap called enterprise value, which tries to measure the value of the actual business itself, stripping away purely financial elements. There are many flavors of enterprise value, but the most straightforward way to calculate it is market cap plus long-term debt, minus cash.

Enterprise Value = (Market Cap) + Debt - Cash

Enterprise value measures how much it would cost someone to buy out all the owners of a company, pay off all the company's debts, and take out any cash that is left over. For example, as of Oct. 31, 2012, General Electric's (GE) market cap was $222 billion, and Chevron's (CVX) was $216 billion. GE had about $272.7 billion in long-term debt and $84.5 billion in cash and equivalents, whereas Chevron had only $9.7 billion in long-term debt but $15.9 billion in cash and equivalents. Thus, Chevron's enterprise value was about $209.8 billion, while GE's was $410.2 billion--a significant difference.

The Meaning of Stock Values

At this point, it's important to remember that a stock's value is determined by the company's underlying performance. It's easy to think of Dell as just a number on a computer screen or a squiggly line on a chart, but the reason it has any value at all is that it is a business that is growing and generating profits. Thinking of a stock as a piece of a business will be particularly helpful in understanding many of the valuation methods we will be considering in the next lessons. 

There are actually two parts to the value of any business. The first part is the current value of all the business's assets and liabilities, including buildings, employees, inventories, and so forth. The second part is the value of the profits the business is expected to make in the future. Some companies get most of their value from the first part. These types of companies tend to be mature, stable businesses without a lot of growth prospects, such as utilities and real estate companies. For these firms, the assets are in place, and the future cash flow is relatively predictable.

On the other hand, some companies get most of their value from expectations of future growth and profits. These types of companies tend to be younger with a lot of growth potential. Many biotechnology companies would be included in this category.

Actual assets and liabilities are a lot easier to measure than hypothetical future profits. This is one reason stocks of younger companies tend to be more volatile than their more buttoned-down brethren. When expectations are high, the market anticipates that future profits will continue to increase, and it bids up the stock. When pessimism takes over, the market expects fewer profits in the future, and the stock price falls. Ultimately, estimating what a company will do in the future is the key to all forms of stock valuation.

Two Approaches to Stock Valuation

There are two broad approaches to stock valuation. One is the ratio-based approach and the other is the intrinsic value approach. We will be looking at both of these in more detail later, focusing on the intrinsic value approach that we tend to favor at Morningstar. But here's a brief overview to get you oriented.

If you have ever talked about a P/E ratio, you've valued a stock using the ratio-based approach. Valuation ratios compare the company's market value with some financial aspect of its performance--earnings, sales, book value, cash flow, and so on. The ratio-based approach is the most commonly used method for valuing stocks, because ratios are easy to calculate and readily available.

The downside is that making sense of valuation ratios requires quite a bit of context. A P/E ratio of 15 does not mean a whole lot unless you also know the P/E of the market as a whole, the P/Es of the company's main competitors, the company's historical P/Es, and similar information. A ratio that looks sky-high for one company might seem quite reasonable for another.

The other major approach to valuation tries to estimate what a stock should intrinsically be worth. A stock's intrinsic value is based on projecting the company's future cash flows along with other factors, which we'll discuss in Lessons 403 and 404. You can compare this intrinsic or fair value with a stock's market price to determine whether the stock looks underpriced, fairly valued, or overpriced.

The advantage of this approach is that the result is easy to understand and does not require as much context as valuation ratios. However, the main disadvantage is that estimating future cash flows and coming up with a fair value estimate requires a lot of time and effort. We think the advantages outweigh the disadvantages when this type of valuation is done carefully. That is why it forms the basis of Morningstar's fair value estimates and star ratings.

The Bottom Line

Finding great companies is only half the equation in picking stocks. Figuring out an appropriate price to pay is just as important to your investment success. A great company might not be a great investment if its stock is too expensive. Likewise, a company of mediocre quality could be a good investment if bought cheaply enough. Either way, it's critical to be aware of the prices you are paying for your stock investments.