If you have to invest intelligently and succeed in your investing, it stands to reason that you should know something about stock valuation. After all, if you have no basis on which to judge the fair value or the intrinsic value of a particular stock, you have no way of figuring out whether the stock is undervalued or overvalued and whether you should be buying or selling. You will be entirely at the mercy of short-term price movements in the market and your own whims and emotions. In fact, speculation without a sound factual basis is nothing but gambling where luck determines your fortunes.
There is a widespread though misconceived notion that valuation is akin to rocket science and is something that should be left to the experts. In an effort to promote its own services, the investment community has created a myth that only investment analysts in brokerages who operate on the sell side have the requisite knowledge and ability to properly value stocks. Nothing could be further from the truth. You do not need to be a CFA or a financial expert in order to carry out your own valuation. All you require is some common sense and the ability to carry out simple mathematical calculations.
Before you start doing your own valuations, there are some basic concepts that you need to understand. For instance, there are a number of people who are unaware of exactly what the share of stock is. It is not some exotic financial instrument but actually represents concrete proof of part ownership of a company that is publicly listed and traded. If a company has 100 shares outstanding and you own one share, you own 1/100 or 1% of the company.
Why would somebody else want to buy your 1%? There are a number of different reasons. A potential buyer might regard your 1% as a worthwhile investment to make and opts to buy it. He may want your shareholding because he wants to exercise the voting power at the annual General meeting. He may even want to buy your shares and combine it with the holding of 50 other shareholders such as yourself so that he acquires a 51% controlling stake.
Apart from individuals who are potential buyers, companies also acquire shares in other companies for a host of reasons. They may wish to acquire another company or at least acquire enough of a shareholding to demand a seat on the board of directors. For any listed company, the stock is on sale on a continuous basis and the share price determines the value of the company. This allows companies that are interested in mergers and acquisitions to determine whether another company is a worthwhile target at the current market price.
Your ownership of stock entitles you to a proportionate share in the earnings, revenues, cash flow and anything else that the company owns or generates. For you as a retail investor, this translates into what kind of dividends and capital appreciation you can expect as a reward. You are entitled to dividends in perpetuity as long as you continue to hold the stock. Sometimes, instead of using excess cash to pay dividends, the company may choose to repurchase some of its shares from the market. This normally results in an increase in the share price because of the reduction in the number of shares outstanding.
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