Stock investing basics
Stocks/Shares
This is likely one of the asset classes you’re most familiar. Stocks, shares: it’s the same thing just different words. A share is a % ownership of a business. These shares trade daily on the stock exchange, the prices go up and down.
Over the long term, the share price will track the value of the business- so if the business becomes more valuable, your tiny % share of ownership will be worth more and you’ll make money. Shares trade on a number of stock exchanges around the world: London, New York, Hong Kong etc. The market represents a collection of millions of buyers and sellers, some people, some institutions and some computer algorithms. If there are more people wanting to buy a share than sell it the price will rise, and vice versa.
When it comes to your return as a stock investor, one of the most important concepts to understand is that there is a difference between the value of a business, and it’s share price. Logically, as each share is a small % ownership in a business, if you add up all the shares outstanding you should get the value of the business. But the stock market isn’t logical, so that isn’t true at all in practice.
The way the stock market measures the value of a business is something called the market capitalisation, or market cap for short. It’s a simple and logical calculation:
Number of shares outstanding x Share price = Market cap
The market cap is the stock market’s representation of the current value of a business. The problem is that market cap isn’t the same as actual business value.
Business Value ≠ Market cap
The value of a business at any time is a representation of the potential future cash flows that business can generate for the owner. If a business is likely to generate significant profit in future, it represents a high value to a potential owner. That is a calculation that is reasonably easy to understand and undertake, and is something that can be ascertained with a reasonable level of accuracy.
Bear in mind it is never a precise science, as the value two different people will place on potential future cash flows may vary, so business valuation in reality is more of a ‘range’ than a hard number, but it’s certainly a range that we can estimate and be reasonably comfortable with. It’s also something that does not change day to day, week to week, or even really month to month. The fundamental value of a business changes slowly over time. If we wanted to buy a business it’s a slow process of due diligence, and we wouldn’t be adjusting our purchase price day by day simply because the value of the asset isn’t changing day by day.
In contrast, the stock market representation of the value of a business (market cap) is a combination of both business value AND many other variables. There are thousands of other variables, but despite the huge number they all share three common traits:
they’re short term in nature
they don’t affect the actual value of the business
they are impossible to predict reliably
They include things like the news cycle, investor emotions, flows of money (who’s buying what), new financial products being issued, changes to accounting rules etc etc.
Don’t try and predict what you can’t predict
The fact that stock prices move away from business value is not a problem- that’s the opportunity. You can calculate business value with a reasonable degree of accuracy (we’ll cover how to do this), and then you can look at the market and see if the stock price is trading above or below that level.
If the share price is below business value, then buy some stock and wait. If the stock price is above business value, move along. Maybe it’ll fall below at some point and you can buy the stock at that point, or if not you’ll be able to find something else.