The Most Authentic Guide on Personal Finance and Investments


Words of Wisdom : "The best time to start thinking about your retirement is before your boss does." ~ Anonymous

When buying stocks this blunder is the biggest of them all

If I ask you to buy a stock whose price is Rs.4000 per share, most of you would experience fear and then most probably say no to it.

If I ask you to buy a stock whose price is Rs.15 per share, most of you would have no reservations and gladly cut the cheque.

Unfortunately, in both instances your preferred course of action would prove disastrous. If it is of any consolation... most people sail in the same boat as you.

This happens because 4000 is a very large number as compared to 15. Therefore, a share priced at Rs.4000 "appears" awfully expensive vis-a-vis the one available at a mere Rs.15.

As you would note, I have highlighted the word Appear. Yes, appearances can be very deceptive. Therefore, what seems to be immensely expensive may instead be quite attractive. On the contrary, what appears to be attractively priced may turn out to be a dud (and dead) stock.

To understand this contradiction, you need to appreciate the distinction between Share Price and Share Value.

Share Price
Market price of a share is primarily determined by demand and supply. If too much money is chasing a given set of stocks, naturally the price will rise; and vice versa. 

Indians, as we all know, have no liking for equity. Therefore, in Indian stock market, Foreign Institutional Investors (FIIs) are comparatively more active than the domestic investors. As such, whenever FIIs are bullish on India and pump in billions of dollars, you witness a sharp rise in the Sensex / Nifty. And when they take money out, the stock markets almost go into a free fall.   

In short, share price is a fickle number that changes from minute to minute, depending on the number of buyers and sellers active in the market at any given moment.

Share Value
A share is not just a simple piece of paper or a ticker on the screen. No. Rather, it represents your "beneficial ownership" in a company. And that company is engaged in some business. 

Now, a business would either make money or lose money. If it is a profitable venture, each shareholder is entitled to that profit (based on his percentage shareholding in that company). Logically, more the profit, the more you stand to gain.

It is this "extent of profit", that a business is expected to deliver, which determines the "Value" of the particular share. In very layman terms, if the company makes Rs.10,000 as profit and has issued 1 share each to 100 persons, each shareholder will get Rs.100. In other words, the Share Value is Rs.100. (Of course, the share valuation techniques are slightly more involved, but the underlying principle of profits determining the Value remains the touchstone.)

By the way, Share Value is a lot more stable number as the prospects and profits of a business do not change overnight.

Margin of Safety
Therefore, it is but natural that a share whose Price is less than the Value is a more sensible buy. In stock market parlance, this is an "undervalued" stock.

And where the Price is more than the Value, i.e. an overvalued stock, it is best to keep away.

This is where we have the concept of Margin of Safety, the success mantra popularized by Benjamin Graham and Warren Buffett. In brief, it means that higher the discount between Price and Value, higher is the probability of making money i.e. the share is comparatively less risky.

Coming back to the example I quoted at the start...
... The Rs.15/share company could be a loss-making one and hence has "Zero Value". On the other hand, the Rs.4000/share company could be exceedingly profitable and hence hold "Tremendous Value". So despite its so-called steep price, it is any day a better share to buy.

Concluding, don't confuse Share Value with Share Price. This is where most people go wrong buying stocks. I am sure you don't want to feature in the list of stock market losers.

You Learn A Lot By READING... And Even More By SHARING.

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Ignorance is like a SIGNED BLANK CHEQUE... anyone can MISUSE it.

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