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What are stocks and how to value them

November 13, 2013

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!

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Lovely comments

  1. DC @ Young Adult Money says

    November 13, 2013 at 6:45 am

    Great write-up on stocks. It’s important to understand the basics of investments before you get lost in the complexities of the market and all the variables that come into play.
    DC @ Young Adult Money recently posted…3 Easy Projects To Get Your DIY Juices FlowingMy Profile

  2. Terry @EasyFinancialTips says

    November 13, 2013 at 10:41 am

    Great post! This is a sturdy foundation for anyone looking to start investing. It also breaks down the logic into easily understandable terms, so anyone can benefit! Thanks!
    Terry @EasyFinancialTips recently posted…Pros and Cons of a BYOD PolicyMy Profile

  3. Jen @ The Happy Homeowner says

    November 13, 2013 at 6:08 pm

    A good idea for a series–looking forward to reading/learning more!
    Jen @ The Happy Homeowner recently posted…Why I Told My Budget to Shove ItMy Profile

  4. Daisy @ Prairie Eco Thrifter says

    November 14, 2013 at 8:18 am

    I was always taught in school ( I took business school so we looked at stocks in a few courses) that we should take a value-investor approach. Then again, I think the teachings depended on the instructor, as everybody has individual preferences. I’m excited for this series!
    Daisy @ Prairie Eco Thrifter recently posted…How to Save on Sports Equipment for KidsMy Profile

  5. romona@monasez says

    November 14, 2013 at 9:38 am

    Very informative. I learned all about stocks and bonds in 8th grade at the private school I attended but I definitely plan to educate myself further over the next month or so.
    romona@monasez recently posted…30 Things I Plan to do Before Reaching the Thirty Year MilestoneMy Profile

  6. Anne @ Unique Gifter says

    November 14, 2013 at 3:33 pm

    All this time, I’ve thought stocks were the things you put thieves into so you could throw tomatoes at them. Who knew? haha j/k
    Anne @ Unique Gifter recently posted…500+ Stocking Stuffers for Adults, Teens and SeniorsMy Profile

  7. robert@moneyrebound says

    November 14, 2013 at 8:07 pm

    Good post. It is amazing how many people move into an investment like this without learning the basics

  8. Kim@Eyesonthedollar says

    November 14, 2013 at 9:44 pm

    This should be a really good series for someone looking to learn about the basics of investing. I think lots of people put it off because they don’t understand, which costs them in the long run.

  9. Brent says

    November 15, 2013 at 12:25 am

    Great overview of stocks and, of course, you had to mention Buffett when talking about stocks! The stock market makes up a portion of my retirement plan and I do love researching stocks.
    Brent recently posted…How Your Credit Score Can Act Like A School Yard BullyMy Profile

  10. Levi Blackman says

    November 15, 2013 at 3:47 pm

    Great start to what looks like will be a great guide to investing. Investing in securities is an important part of financial stability and freedom.
    Levi Blackman recently posted…Finding the Right Investment Platform / BrokerMy Profile

  11. Frank @ Wall Street College says

    November 23, 2013 at 9:53 pm

    This is a great intro to stock market lesson!

    I don’t understand how people don’t know more about the beauty of the stock market. Stocks can generate you passive income, in other words you can make your money work for you!! There is no more beauty than that. Therefore I have been constantly investing every penny that I’ve saved. I encourage everybody to make a smart decision and turn off their Tv’s and start learning about the stock market.

    Great Post.
    Frank @ Wall Street College recently posted…10 Reasons Why People Fail When They Start Investing Pt 1My Profile

  12. Mick says

    May 9, 2015 at 1:33 pm

    Great great great great write up and intro to the world of securities. A nice place for beginners to start their journey into the market world.
    Mick recently posted…Weekly Swing Trade Recap Video – May 8, 2015My Profile

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