Imagine you had 1,000,000€ right now. How would you invest it? I’d argue that most people (in Finland at least) would buy property to rent out. Most buyers would compare properties, evaluate the condition and try to figure out how much they could rent it out for. All while trying to get it for the best price possible. For whatever reason, people don’t do this with stocks. An apartment or a company are both assets, which can produce cash flow.
Private Market Rationality
If you have an interest in business, you might look into different companies to allocate the 1,000,000€. On the private market (companies that are not listed on exchanges) you would negotiate with the seller of the business. You try to see into the future what the company looks like, how much it will make, does it have a competitive advantage and can you get it for a good price. Of course, the seller would likely be very knowledgeable of what their business is worth. This means they would likely not part with it for less than its worth (i.e. the total amount of cash the business can produce for it’s remaining lifetime). Most likely, you would buy the business for its fair value, or a premium.
Stock Market Irrationality
Enter the auctions-driven stock market. What this means is that buyers and sellers enter competitive bids simultaneously. The price at which a stock trades represents the highest price that a buyer is willing to pay and the lowest price that a seller is willing to accept. Supply and demand determines price, though company fundamentals play a role too. The beauty of the market is that buyers and sellers are participating with different motives. Due to these differences, the quoted price of a stock can differ between the real value of the underlying business. It can either be under-priced, fairly priced or over-priced. Where do you want to be when you buy? I think the answer is obvious.
The public stock market dilutes our perception of what stocks actually are. Though stock prices may change daily, this only represents where the “auction” stands today. Real change (or value) in business does not happen as quickly as stock prices fluctuate. Stocks represent ownership shares of the entire business. If you can evaluate what the business is worth, divide that number with the shares outstanding you can come to an estimate of what the per-share intrinsic value is. It perplexes me that major financial institutions use terms such as “target price” for stocks. Price and value can differ greatly!
The Market Will Revert To Value. Eventually.
If you have a background in finance, you’ll know there are different ways to value businesses. For the average investor who wants to learn how to value businesses, I believe there is only one valuation method needed; the discounted cash flow, or DCF. This represents the total amount of cash the asset (business) will produce during its lifetime. You can check out my post on the simple way to value a business here.
When buying stocks, have the same mindset as you would when buying a property with renting intentions.
-IGTSKasimir
Further Reading
Warren Buffett – The Partnership Days (1956 – 1969)
Philip A. Fisher – Lessons From The 15% Man
The Best of Ben Graham – Security Analysis
Phil Town – The Compounding River Guide
Margin of Safety – The Most Important Thing
Intelligent Investing = Thinking In Probabilities
The Emotional Stages of a Value Investor
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