A Basic Guide To Stocks: Part 1

 Monopoly

Have you ever played Monopoly?

When I was younger, I played often enough that the complex strategic nuances of this apparently innocent family game soon became evident. To win Monopoly, you have to exploit people’s misconceptions of property value.

The navy blue properties, at the end of the board cycle, are the most expensive and have the highest ‘rent only’ commission. They must be the best investment of your capital – right? Wrong.

The navy blues are expensive to buy houses on; it costs less to buy hotels on all the light blues than it does to buy two houses on each of the navy blues. On average, this generates more profit per land and there is a notably greater chance of a land occurring.

The Stock Market

The first thing you should know about the stock market is that the price of a company’s shares is not a precise indicator of that company’s intrinsic value; it is a reflection of public confidence. This means that the market’s perception of a company’s value is almost certainly not quite correct. Just like effective Monopoly players can win the game by making strategic deals on the basis of other players’ misapprehensions, good investors can establish great wealth by capitalising on the market’s misconception of a stock’s true value.

There are two core techniques that guide the decisions of investors when trading stocks: fundamental and technical analysis. In the first part of this two part series, I will talk you through the core concepts of the former.

Fundamental Analysis

Fundamental analysis aims to uncover the ‘true value’ of a company. If the intrinsic value of a stock is higher than its market value, it is a good investment: buy. If the intrinsic value of a stock is lower than its market value, it is a bad investment: sell.

Fundamental analysis is a complex discipline, incorporating a number of macroeconomic (relating to wider economy and market performance), microeconomic (relating specifically to the company’s performance), quantitative and qualitative factors. There are several common metrics used to quantitatively gauge company value and performance. The price to book (P/B) ratio is one; it compares stock price to the sum of a company’s assets minus its liabilities and is a crude method for estimating a company’s present value. The price to earnings (P/E) ratio is another; it compares share price with earnings per share, allowing an investor to anticipate the rate of return on an investment: an indicator of performance.

DCF (Discounted Cash Flow) analysis is an established quantitative methodology for estimating intrinsic value, based on projected cash flow. A company’s future cash flow is calculated based on recent trends and used to pseudo-retrospectively estimate the company’s present value. All the basic information needed to make such valuations are publicly available company earnings reports.

DCF analysis is unquestionably useful, but does not necessarily provide accurate estimations of intrinsic value in that it does not account for market competition and its effect on future company performance. This is why some investors prefer to establish a relative valuation of a company, against its competitors.

A common method used to ascertain future market influence is to compare the P/E ratios of company’s within a market sector.

Qualitative analysis is yet another factor to consider. This relates to the effectiveness of a company’s management: how good they are at inspiring and engaging their workforce, and how efficient they are in achieving results. Some of the world’s most accomplished investors, such as Warren Buffett, attribute much of their success to qualitative analysis.

If time permits, both quantitative and qualitative analysis should be considered when buying or selling stocks on the basis of fundamentals.

Sector Head: Aaron Hobb

Analyst: Charlie Gregg

 

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