Monday, March 17, 2008

Stock Market For Beginners - Price & Value

Stock market investing beginners need to understand the difference between price and value.

In my last post Stock Market For Beginners I discussed the basics of what the stock market is and how it works in simple terms. Hopefully those wanting to get started investing in shares will have got a good grounding buy reading the post. If you haven't read it yet, I suggest you go and read it now.

In the article I briefly discussed price and value - two very important investment concepts. I didn't go into the difference in any great detail, except to say that the price of a stock may differ greatly from what the underlying value in the company. Today I want to discuss this concept in greater detail.

The price at which a stock trades is a function of normal market forces - that is supply and demand. Regardless of the underlying value (or lack thereof) in the corporation whose shares are being traded, the price will only be what someone is willing to pay. Human emotions, both fear and greed frequently seem to have a large bearing on the price at which a company's stock changes hands.

We've seen it again and again through the history of stock market investing. The market booms and then it crashes. Think the dot com boom, the crash of 1987 and so on. For those that aren't familiar with these events, the prices of shares increased by a large amount in a relatively short period of time to reach unsustainable levels. As the prices increased, more and more investors (or perhaps more accurately speculators) bought in hoping to make a quick buck. This caused prices to keep rising which in turn led to more buying.

Eventually investor sentiment changed and nobody wanted to buy the shares anymore. Even worse, everyone panicked and tried to sell at the same time. If you'll recall earlier, I said that the price of a share will be whatever someone is willing to pay for it. When nobody wanted the buy the shares, sellers had to drop their price a great deal before anyone was willing to buy.

This brings me the the value of a share as distinct from the price. The value of a stock is dependent on the underlying value of the company which issued it. How much cash can it generate? What are it's assets and liabilities? And so on...

During many past stock market booms, the underlying value of companies didn't increase by very much, yet the price of the stock increased by a great deal. Similarly, when the stock prices of some companies dropped by more than 50% in a matter of days, the value of the companies themselves hadn't changed by anywhere near that much (if at all).

Typically, while the value of a company changes relatively slowly over time, hopefully for the better (but sometimes for the worse), the price of a company's stock changes much more quickly. The stock price of some companies can differ greatly from the underlying value, both on the upside and the downside. This a very important investment concept - the price and value of a stock are not necessarily the same.

This is where value investors like Benjamin Graham used things like Dividend Investing and Price To Earnings Ratios to try to exploit these differences between price and value. Graham believed that if he could buy shares which were at a steep enough discount to their underlying value, he would profit when the share price increased and the gap between price and value closed.

The main thing stock market beginners need to remember is that the price a company's share trades at is based on market forces - the perception that people collectively have of a company. And while this consensus view is mostly correct, there are times when the market get it wrong - but on an individual stock level, but also with regard the stock market as a whole.

You have a choice as to whether to buy or sell at a particular price. Don't take the stock market at face value. Make sure a high-priced stock is worth what is being asked - look at its fundamentals. Exercise some skepticism. Similarly, don't pass over the market pariah until you're sure there is no value there. If the market isn't interested in a particular company and marked its price down, this is a good place to start looking for value. But again, be sure of the fundamentals.

If stock market beginners keep this difference between price and value in mind, they will be well on the way to a successful investing career.


Anonymous said...

I just wanted to say thanks so much. I find your posts to be incredibly helpful and easy to understand. I look forward to reading more in the future.

aussie said...

Hi Jennifer, you're very welcome. Thanks for stopping by and providing some feedback. I really appreciate your kind words.

Anonymous said...

Thanks very much aussieinvestor! Im ready to get into the stock market soon and reading your posts has strengthened my knowledge and I hope to get some more value out of future posts

aussie said...

Wes, thanks for taking the time to leave a comment. Investing in the stock market can be both exciting and a little scary for beginners. Just take your time, keep learning and have fun.

Anonymous said...

The market cap is one of the easiest ways to check the overall valuation of a company at a given point in time. Easy way to compare similar companies and see which ones are over-/undervalued.

market cap = #fully diluted outstanding shares X stock price

Steve Selengut said...

Value Stock Investing - The November Syndrome On Drugs

Every fall, especially in opportunity rich markets like this, I encourage investors to think about some year-end strategies that make the final calendar quarter a special time in all markets. Several forces are at work, all of which have links to conventional Wall Street wisdom; none of which promote good long-term investment decision-making.

This year, we have the added excitement of anticipating a new, perhaps economically too liberal, administration taking over with an already implanted, and demonstatably inept, congress. The markets are in a truly unprecedented state of "uncertainty overload". What's an investor to do--- or not to do?

Typically, the November syndrome has features that impact in both directions. It causes weak prices to fall even further and strong prices to climb higher. This year, the strong category requires a microscope for candidate viewing, while the weak seem to have inherited the listings. Money Market funds and Treasury securities are the low yielding, lower-risk, depositories of choice.

At the individual investor level, the mad dash to lose money on equity securities has begun. The idea that this is somehow a good thing is an anomaly created by a counter productive tax code and an industry that has a vested interest in perpetuating the absurdities it (the IRC) creates.

Assuming that we are dealing with investment grade securities, lower prices should most logically be seen as an opportunity to add to positions cheaply--- not as an opportunity to reduce one's tax liability on investment earnings. There is, and never will be, a good loss or a bad ---.

Naturally, both you and your CPA feel better with lower tax bills, but why sell a perfectly good security at a loss to produce pennies on the dollar in tax relief? Speculations, sure, valueless securities, why not? But when nearly all IGVSI stocks are at their lowest levels in decades, selling for losses should be the last thing on your mind.

Most IGVS companies remain profitable. Less profitable, for sure, but few have cut dividends and nearly all will survive and prosper when the economy recovers. Would your CPA accept just half his fee to save on his own taxes? Would you barge into your boss' office and demand a pay cut?

In the old days, when markets moved slowly and buy-and-hold was the investment strategy of choice, the 30-day, buy-it-back, tactic was an effective way of having your tax break cake and maintaining your portfolio as well. But with 1,000-point weekly swings, there are no guarantees that the markets will tread water for your personal tax convenience.

In fact, more often than not, major corrections such as this one produce either a Santa Clause rally or "January Affect" that is far more profitable for November-low buyers than for tax-motivated sellers.

Similarly, "letting your profits run" to push the dreaded taxes into next year is foolishness. Talk to the geniuses that didn't take profits in 1999, or in the '87 or '07 summers. The objective of the equity investing exercise is to take profits--- the more quickly and more frequently, the better. This year's volatility has produced hundreds of profit taking opportunities.

Another popular year-end shell game is the "bond swap", which preys on the fear most income investors experience when their somewhat guaranteed, income securities, fall in market value. This is the same absurdity that allowed "mark-to-market" accounting rules to crack the foundations of financial institutions around the world.

A contract (from a quality borrower) to pay a fixed rate of interest, and full principal at maturity will vary in price throughout its existence. It's nothing to be particularly anxious about. Junk bonds are for speculators, not for those of us with gray-templed children.

Bond swaps allow an advisor to pick your pocket by exchanging them at a "nice tax loss" for another bond with "about the same yield". He gets a double dip (invisible) commission and you get a bond of longer duration or lower quality.

On the same page, the idea of exchanging a steady, much-higher-than-normal-yield, closed-end-fund (CEF) cash flow for an overpriced T-Bill yielding less than 1% is above Emperor's New Clothes absurdity levels.

But there are even more year-end games going on to take advantage of your confusion. Wall Street gangs up on you with a self-serving strategy blithely referred to by the media as "Institutional Year End Window Dressing"--- a euphemism for consumer fraud.

In this annual ritual, mutual fund and other institutional money managers unload stocks (and CEFs) that have been weak and (usually) load up on those that are at their highest prices of the year. This year, they'll be holding cash and Treasuries.

Always keep in mind that (a) Wall Street has no respect for your intelligence and (b) the media "talking heads" are entertainers, not investors. Institutions must paint a picture of brilliance in their annual glossies. This year, a panic-stricken Main Street is helping them with their annual "sell low" hypocrisy.

It would be an understatement to say that these year-end tax and face saving activities are misguided and unnecessary. But this year's "November Syndrome" is an unprecedented investment opportunity that most people are too confused to appreciate.

Simply put, get out there and buy the (high quality) November lows, both equity and fixed income. Establish new positions for diversity, and add to old ones without surpassing "working capital model" diversification limits. Keep appendages crossed for a therapeutic dose of "January Affect" elixir, as you reaffirm your understanding of long-term investment strategy.

The media will talk about this New Year phenomenon with wide-eyed amazement. Most of those terrible losers (you just sold?) begin to rise from the ashes, as the professional window dressers repurchase the solid companies they just sold for losses--- interesting place Wall Street.

One last thought; if you have taxable profits that you can't bear the thought of holding on to, just send the profit portion to me. I'll pay the terrible taxes.

Steve Selengut
Professional Investment Management from 1979
Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"

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When it comes to stock investing. I always stress stocks with very low price to sales ratios. Because theirs nothing else that gives the investor a bigger advantage in the market than this metric.

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Unknown said...

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