The theoretical value of any cash generating investment, whether stocks, bonds, real estate or a private business, is the present value of all of its future free cash flows, discounted back at an interest rate reflecting the risk of those cash flows. That means every year of free cash flows (whether positive or negative) are discounted back to the present at an appropriate discount rate.

This is easy to see and do with bonds, since the cash flows of a bond are established by contract and the general risk of the bond is known. For example, a bond that was issued at $100 and pays 5% interest income ($5) annually and then repays the $100 principal at the end of 10 years would be worth $100 today if the appropriate risk-adjusted interest rate for discounting those cash flows back to the present is 5%. It would be worth more if the appropriate discount rate were lower and it would be worth less if the appropriate discount rate were higher.

However, stock, real estate and private businesses do not have their cash flows set by contract. Their annual cash flows can vary significantly. And it is not always clear what the appropriate risk-adjusted interest rate is for various stocks, real estate or private businesses. Thus, while “discounted cash flow (DCF)” analysis is the theoretically correct way to value any cash-generating investment, it is usually not a practical way to assess the value of a stock.

Common short-hand methods for assessing stock valuations are to use ratios of the stock price to various fundamental accounting metrics. The most common stock valuation metric is the P/E ratio, which is the stock price (P) divided by the EPS (E) of the company. EPS stands for "earnings per share", which is calculated as net after-tax profits divided by shares outstanding. While it varies by industry, low-growth “value” stocks tend to trade at P/E ratios below 10x or 15x, while high-growth stocks tend to trade at P/E ratios of 20x or more.

Other commonly-used valuation metrics include Price/Sales per share, Price/Book Value per share (which is another name for shareholders’ equity or net worth) and Price/Free Cash Flow per share. It is helpful to look at these valuation ratios in comparison to peer group companies and to their own history to determine whether a given stock is overvalued or undervalued. However, “undervalued” stocks can become much more “undervalued” if their fundamental operating results are weak and disappointing, while “overvalued” stocks can become much more “overvalued” if their fundamental operating results are strong and better than expected. This is because investor expectations of all future cash flows of the business determine the value of a stock, not the cash flows of any one particular year. Thus, it’s important not to focus solely on valuation metrics when determining whether to buy a stock or not.