Saturday, 10 October 2009

Looking at the Intrinsic Value of a Company

I don't think I've covered a basic introduction to the stock market or the intrinsic value of a company in any of my posts so far so I'll run through some simple terms so we're all comfortable! I know the stock market can be confusing for lots of people out there including myself. When I first started out buying stocks and shares I felt like there was no way I'd ever get a good handle on what all the terms mean and the TV shows move so quickly. The hosts often assume you know what they're talking about and so skip over what each term means and leaves viewers (like me) even more confused and disheartened by the whole process! How can I work out which stocks to buy if I don't know what they're talking about! I know a lot of people out there look at the stock market as a form of gambling. Take a leap of faith to today on a hot stock pick and then sell it again the next day making a nice little profit! Yes that is gambling and it's something I'm telling my readers not to do. There's no science behind this process you're relying on hunches and luck and to be brutally honest the market doesn't care about you or your money. There's no one out there determining if its your lucky day so do your research! Don't take any leap of faith with your cash. I know I don't, I like mine too much to throw it away on Jimmy McShoes warehouse stocks!

So we've agreed we're not going to gamble right? So we're looking for long term investments. The next question is how do we identify a long term investment. The secret to this is working out the real or intrinsic value of a company. By this I mean you should be able to look at a companies balance sheet and work out if it's worth $40 a stock or $1 a stock regardless of what the market is. Once you work out a companies true value you can spot bargains and snap up the hot stocks. You won't have to sit and listen to the TV hosts recommending whatever the buzz stock is as you'll have your own research and analysis to call on. It's much more satisfying knowing you've done the research and watching that share price rise and rise over the years. Yes I said years! Buy and hold. Buying stocks just to dump them the next day won't make you any serious money in the long term. You'll end up losing large amounts of it by all the trading fees the stock brokers charge you for each transaction. This is of course all relative to the amount of money you're investing but if you're just starting out I don't imagine you'll have bags of money to throw at this. That's why it's so important to have done your research and make your stock and share choices wisely. Oh and diversify your stocks portfolio!

The dividends a company is paying out each year is a good indication of what profit it is actually making. John Burr Williams is a famous investor who recognized that a companies intrinsic value is key to determining the worth of stock. He famously stated that earnings are only a means to an end, and the means should not be mistaken for the end. A stock derives its value from its dividends, not its earnings. In summary a stock is only worth what you can get out of it. If it's not showing any returns is it worth buying? A stock is only worth the returns it will generate for you. You can get all this information from the companies balance sheet which is available for free in most cases from the company itself. How to buy stocks for beginners can be confusing especially when starting out but companies balance sheets are generally easy to follow. Unfortunately calculating the intrinsic value of a company will spark a debate between investors as there is no 100% perfect way of doing it as some of it is based on projected earnings which as you can imagine is never going to be perfect. There is software out there that will do this for you but it won't be any more accurate than doing it yourself. It will only act as a time saver. Make sure you read up on the software before you buy it too as you never know how they are calculating the intrinsic value. It might be completely different from the way you have found to value a company and so you may end up buying stocks that are not worth the price. We're interested in value investing after all and looking for undervalued stocks to buy.

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