Basics 3 – Valuation

To profit from the stock market, we need to estimate if stock prices will rise, or fall. The 2 things we need to know are the current price and a target price.

Keypoint 1: Valuation is the act of estimating how much a stock is worth.

There are 2 ways to valuate a stock

  • Fundamental analysis – Value a stock base on how much a company is worth, or long term/ intrinsic value a of a stock
  • Technical analysis – Value a stock base on market trends, sentiments, price actions, or short term/ market value of a stock

When we value a stock, we are using certain reasons or views to gauge how much a stock should be worth. As an investor, we make use of the difference between current price and our valuation to make money on the stock. If prices are too high now, we sell it, and buy a stock if prices are too low.

There are 2 important concepts to grasp before we go into actual methods of valuing a stock in our next article.

1. Price is not value

Whether a stock is selling at $0.50 or $50 per share isn’t what makes it cheap or expensive. What is expensive would be a share selling at $0.50, when the value of the company is $0.10.

The price of a stock is what the market, at that point in time, thinks a company is worth.

If you have an apple and 50 people are trying to buy the same apple, the apple may cost $1,000. Whether or not the apple is actually worth $1,000 doesn’t matters, price is that the market thinks it is worth.

price-vs-value
Price and value are 2 different things

By using valuation, we are able to give an estimate value to the company. For example, the company may be fundamentally worth $1100, or technically the trend should continue till $1100. In this scenario, a $1,000 price tag for the company would be cheap.

If an investor enters the market without some form of valuation, they do not have an internal measure. Their view would be highly influenced by the market, leading to buying a stock when prices are obviously too high (etc buying an apple worth $1 at $1000). Its similar to going to an auction house without knowing how much each antique is worth.

Key point 2: The stock prices doesn’t determine if a company is cheap or expensive, valuation does.

Key point 3: If you can’t value a stock (don’t understand, not familiar etc), avoid it

2. You get paid for being right

At the end, investing is about how much money it makes. In order to make money, one should be right as often as possible.

Lets compare 2 valuation:

  • 1. A 10% potential increase from current price, 75% certainty
  • 2. A 20% potential increase from current price, 50% certainty

Investors that picks option 1 frequently would be rewarded more than option 2. This is because of 3 factors:

 

Position sizing

In an uncertain trade, a rational investors would risk an amount they are able to lose, often 5% or less. For a 5% position size trade, a 20% profit gives you 1% total portfolio returns. This happens 50% of the time.

In a certain trade, one is able to go up to a larger amount. For a 10% position size trade, 10% profit also give you 1% total portfolio return. This happens 75% of the time.

 

Less activity

A good opportunity doesn’t come happen everyday. To be able to find high certainty investments with high potential, one would need to look through a large number of potential companies.

Only entering into trades that requires a high level of certainty would limit the amount of trades you do each year. Trades, as well as commission, are proven to be a drag on portfolio performance.

Price increase tends to happen on a few days in a whole year. If you are out of stock during those days, you would miss the increase. Being too active on investments tend to bring about a lower return than buy and hold strategy.

 

Losses

Investing is about using money to make money. Capital, or the amount of money we have for investment, is the lifeblood of investing.

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Making 10% and losing 10% is not the same. When we lose 10% of our portfolio, we need to earn more than 10% to make it back.

E.g A loss from $10,000 to $9,000 would require us to make $1,000 with the $9,000 we have now. That’s a return of 11.11% for us to get back to our original capital. The more you lose, the harder it is to make it back. (Losing 50% would require you to double your capital to make it back)

When you lose money, you are reducing your future ability to make money from investing.

Key point 4: Concentrate on what should happen, not when it happens. Be certain in investments.

Key point 5: Never enter into a risky trade because of greed. Its better to miss that opportunity than to miss all future opportunities (by losing capital).

Different methods of valuation provides differing level of certainty. For us, fundamental analysis provides a higher level of certainty because it’s based on the facts and figures of the underlying company, and stock prices tend to follow how the actual company has been performing in long term.

Simple investors basics
Basics 2 – Buying stocks | Chapter List | Basics 4 – Fundamental Analysis

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