There is always a common question asked in the investing world, particularly in the stock market, almost daily or even hourly, regardless of investors, traders or speculators…
“Why did the share price drop?
What happened to XYZ Company?”
At first, if you involve yourself in the stock market, you must be clear about the definition of share price. Let’s refer to the definition from Wikipedia:
“A share price is the price of a single share of a number of saleable stocks of a company, derivative or other financial asset.
In layman’s terms, the stock price is the highest amount someone is willing to pay for the stock, or the lowest amount that it can be bought for.”
In a nutshell, a listed company will be tagged with a price and publicly traded in the stock market. So what could a share price tell us about a business directly? As a quick answer for the question, there is no direct relevance between the share price and the underlying business at all.
Price or Value?
Yes, you understand correctly, there is no romance relationship between two of them. The price is only a proxy of a company’s value. We could not pay anything in terms of “value”, so the business must be priced with a number in dollar term. Let’s assume yourself as an investor, should you focus on a price or value (of the business)?
The answer is both!
As far as the share price is important, it does not mean you should track the price movement as frequent even if you are in the toilet (I think I should not go there…you know what I mean). The importance of either the share price or the company value comes in sequence.
Value is the key
Let’s continue to put yourself as an investor, you should evaluate a company’s value through understanding of the business first, what are the company’s advantages to remain competitive in its industry which allows them to stay alive in business for longer term. Not only that you need to find out the strength of the company, you may ask yourself, as an investor, the following 2 important questions before you price the business which you might be interested to own:
1. With the above strength, how could the company grow and provide more value to society?
2. What could be the potential risk when the company is growing to a higher stage?
Price the business
You should give them a price tag after evaluating the business activities. A commonly used method will be the Price to Earning Ratio, or in short term PE ratio. It basically tells us how many times you are willing to pay in term of their earning or in other words, how many years does the company take for you to breakeven, assuming the earning remain unchanged. It gives you a clear picture of how much you are willing to pay for a business, a quality organisation. However, who does not like to pay less for a supreme quality stuff? Even Warren Buffett said this:
“Long ago, Ben Graham taught me that ‘Price is what you pay, value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down”
Be a smart consumer, buying a quality stuff at cheap price or at least at fair price. In investment, ignore the short-term swing in price but emphasizing the underlying value that you will get in the investment which could be the capital gain for example, if the company’s value increase over time.
Let me assume Milo (a product by Nestle) is your favourite drink and take it as an example. Imagine that you are in the supermarket, shopping and picking the groceries for your week ahead and you discover that Milo is on sales, let’s say down to just $23.90 per litre from the usual $29.90, a full 20% down. Ask yourself, does the weight of Milo varies due to price change? Does the taste change due to the price difference? It is clearly a no, you understand what I meant.
You should understand the price which is determined by the market, will not tell you anything about a business, how a company’s business activities perform, but you should learn a way to value a business by identifying the strengths and weaknesses, growth and risk of the company then give them a fair price tag and get the reference from the market instead of making up your mind by taking the price which market is currently offering. Continuous learning should give you an edge of picking a good company and paying for a fair price!
Disclaimer: All facts and opinions presented are for educational purposes only. This is not a recommendation to buy or to sell. The author involved in the writing of this message has no vested interest in the companies. Please consult a professional for expert financial or other assistance or legal advice.
This article was written by Team VIC
Team VIC is formed by experienced and well-trained individuals from Value Investing College (VIC). The team has been consistently studying the latest stocks market trend in order to focus on educating the layman on investment principles and techniques.