What are stocks and how to value them

Morning! Please welcome back Troy who is starting an investing for beginners series.

 

I’ve been emailing Pauline, and I’ve decided to publish an “Investing for Beginners” guide here on MMYW. Below is a brief breakdown of what we’re going to cover. In total this is going to be a 30 post series.

Part 1

Part 1 is all about basic definitions.

1. What are stocks & what is the appropriate value for a stock.
2. How does Currency Trading Work?
3. What are Commodities?
4. What are ETF’s
5. What are options

Part 2

Part 2 is all about investment strategies & the respective risk management strategies that go with each strategy.

Today’s post is going to cover the basic definition of a stock and the appropriate value for an individual stock.

Definition

I’m going to make this part short because I want to focus on the Appropriate Value for a Stock in this post. A stock is essentially just a share in a company. If you own a company’s stock, you are essentially part-owner in that company. For example, if Apple has 900 million outstanding shares (meaning that there are a total of 900 million shares of Apple around the world). If you own 1 share of Apple, you are officially 1/900 millionth owner of Apple.

Now there are two ways of looking at stocks.

1. Viewing a stock as part-ownership of a business.
2. Viewing a stock as nothing more than an investment vehicle.

Warren Buffett views each stock as part-ownership of a business – that’s why he’s known as a value-investor. Value investors will buy stocks in a company if the business’ assets are worth more than it’s “official price”, aka its market capitalization.

On the other hand, most traders and investors see a stock merely as an investment vehicle. If they think buyers will push up the price of the stock in the future, they’ll buy it today.

So the question is, why doesn’t every look at stocks like Warren Buffett does? Because not everyone is as rich as Warren Buffett. Here’s an example.

Let’s say Company A’s assets are worth $1 billion. And let’s assume that it’s market capitalization (official price on the New York Stock Exchange) is $100 million. Thus, in Warren Buffett’s eyes Company A is a steal – you’re buying $1 billion worth of “goods” for $100 million (90% off!). Thus, Buffett would buy a lot of shares, say 30% of the company for $30 million.

If the stock price goes up because other investors recognize how undervalued this company is (90% off!), Warren Buffett will earn capital gains (profits on his investment).

But if the stock price doesn’t move, Warren Buffett can still profit! It’s unbelievable! He can just buy the rest of the company for $70 million, shut Company A down, and liquidate all it’s assets for $1 billion.

So either way, Warren Buffett makes money because he has enough money to buy the whole company! Now obviously you and I cannot do this – if the stock price doesn’t go up, we do not profit because we can’t buy the whole company and liquidate it.

That is why every investor and trader must see a stock as nothing more than an investment vehicle. Which leads me to my point.

Appropriate/Fair Value

This is the question that all investors ask – what is the fair value of a stock price. What should the price of Stock XYZ be?

The reality is – any price you want. There is no “fair market price”.

Take Netflix as an example. Netflix is a “story company”, meaning that it’s real value as a company (corporate profits, assets) equates to practically zero. Netflix’s P/E ratio (price of stock vs. earnings) is 275, meaning that if Netflix’s stock is $300, it’s making just over $1 per share.

But even at such ridiculous prices, many investors still say that Netflix is “undervalued” (meaning that it’s “fair value” is more than $300 a share). That’s ridiculous! You can define undervalued/overvalued in any way you want.

Take oil prices as an example. Think back to 2008 when oil prices were approaching $140 a barrel. At that time, legendary investor Warren Buffett said that “oil prices were undervalued” – that’s why he bought oil.

Within a year, oil prices crashed to $50 a barrel.

The point is, do not invest just because you think a stock is “undervalued”. If you need investment advice for share trading, do your research. You will be able to find a bajillion reasons even for the most ridiculous stock to be called “undervalued”. In the following posts, I will explain exactly how you should invest in stocks, bonds, currencies, and other assets.

See y’all next time!

This post was featured on the Carnival of Financial Camaraderie, thank you!