Investing in Shares Part One
Investing in shares has many moving parts, lets try and break them down.
Stage 1 Determine if investing in Shares is ok for you.
Before you invest you must consider and answer three basic questions
- What’s your investment objective?
- What’s your risk profile?
- What’s your investment duration?
Let’s consider in detail
- What’s your investment objective?
Are you investing for Capital Appreciation? i.e. to take risk and appreciate your invested capital or are you seeking Capital Preservation, i.e. preserving your invested capital from capital depreciation at all costs?
If your objective is Capital Preservation, then you should not invest significantly in the stock market, as the stock market is extremely risky and you may lose all your invested capital.
- Risk Profile
How much risk are you willing to accept? If your risk tolerance is low, then do not invest in the stock market.
High risk does not automatically translate to higher return.
- What’s your timeline for investing?
All things considered, Capital Appreciation has a better chance of occurring when you stay invested in the stock market.
So if your younger, you should allocate more of your investment capital to the stock market to take advantage of its capital appreciation benefits. Yes, the risks are higher but your longer investment duration allows you take that risk.
If your approaching retirement age do not invest in the stock market as you have less time and less margin for error with your invested capital
Once you answer these questions we proceed.
Stage 2: Understand the Difference between the Share Price and Intrinsic Value
An important concept to understand with shares is the difference between the market price of a share and Intrinsic value of a share.
The share Price is simply what the stock market offers that share to the public to be purchased.
The Intrinsic Value: is what the share is worth based on fundamentals both tangible and intangible.
The intrinsic value and the share price are never the same, its either the share price is at a discount to the intrinsic value (underpriced), or the share price is at a premium to the intrinsic value (overpriced) Remember this.
So when do you buy a share? You want to buy when the share price is below the intrinsic value of the share. Its important to buy a share with a good Margin of Safety, ie a good gap between the intrinsic price and the share price.
Stage 3: How do we apply the concept of Share Price and Intrinsic Value?
Let’s look at the share price first, if Company A has a share price of N100, what does it mean? It means N100 equals the present value of all future dividends the investor will get. To be very simplistic, if you buy Company A shares for N100, you will get back dividends, if we discount all those dividends back to today, the dividends will be worth N100
Now what if Company A will gets a huge new contract next week? its revenue will go up, thus the potential dividends will go up (all things being equal), thus the intrinsic value goes up, but remember the share price is still N100, so a good buy opportunity.
If I buy at N100 today, I am in play to receive more dividends. The market will later recognize this and the price of the share will go up to say N110, but I already bought at N100.
what if the company get a huge new competitor? The revenues may go down, intrinsic value falls, but share prices is still N100, so I consider selling.
Lets summarize
If future earning are projected to fall, then the share price will eventually fall, so the stock is overpriced now, don’t buy or sell
If future earnings are projected to rise, then the share price will eventually rise, so the stock is underpriced now, buy now, or don’t sell
Note” we have not discussed how to determine the fundamental Value of Company A, lets do that next week.
(picture credit: elearn markets)
