There are many methods that stock market analyst use to measure what the true and fair market value of a stock or bond should be. They then use this information to invest and give investment advice according to whether they believe the stock is overvalued or undervalued currently. One of the most important and frequently used calculation that these analysts use is known as discounted Present Value. Let me illustrate this calculation with an example. Assume that you have a friend who needs a loan. He guarantees that after two years he will pay you a sum of Rs1210. The present rate of interest that is applicable is ten percent. You should loan this person a sum of Rs1000 today as this is the discounted present value of Rs1210.

What this means is that the amount of Rs1210 is 'discounted' or brought back to a figure of Rs1000 today as it is the equivalent of that after adjusting for time. Discounted Present Value is also known more commonly as Present Value Technique. The calculation is quite simple and I will show you how to apply it.

There are three main things to keep in mind to calculate the Present Value. One is the rate of return or the interest rate. This is symbolized by the letter 'r' in this formula. The second variable is 'n' which is the number of years you are trying to calculate the amount for. The last variable is the amount of promised payment, Rs 1210 in the example above. The formula is as follows: Present Value = Promised payment/(1+r)to the power 'n'. To add to this example, let's say that your friend has offered to pay you after the first year a sum of Rs1100 and after the second year a sum of Rs1210. Now you should loan your friend Rs2000. You can get this figure by applying the same formula. Simply treat each year as separate. First apply for year one, then apply for year two and add them both up.

As I previously mentioned, this method of Present Value is often used to value stocks and bonds as well. The fair market value of stocks and bonds is dependent upon future expected cash flows which are then discounted at a rate that is equivalent to the amount of risk that this particular stock or bond faces. The reliability and certainty of the expected cash flows is the main concern and while this formula just deals with numbers, there are many other factors that go into valuing a company as well. Let's look at how stocks and bonds can be valued using this technique

Let's take the example of bonds first. If you wanted to buy a bond, the future cash flow each year (they have annual payments) is expected to be Rs 60. This is known as 'coupons' in the world of bonds. The maturity value is also known with as much certainty and let's says this is Rs 1000. You now apply the same formula at the risk free rate that the bond is supposed to give and you will get the correct value of the bond. In some cases the market price quoted by some dealers is below the fair value, but this will increase demand and it will soon be equal to the fair value.

Now let's look at stocks. In the case of stocks, the cash flows that accrue are known as dividends instead of 'coupons'. These cash flows are subject entirely to market risk and these future payments are not guaranteed. Once can only try and forecast them. Since the risk is higher in stocks than in bonds, the 'discount rate' that you will apply here, will include the 'risk free rate' as well as an extra amount known as the 'risk premium'. The fair value of the stock will again be found by applying the same formula.