Every time you invest in a company by buying its shares, you become a part owner of the said company. Now, investing in shares has so many moving parts. Here, we will break them down.
Stage 1: Determine if investing in shares is okay for you. Before you invest, you must consider these three basic questions:
1. What’s your investment objective?
2. What’s your risk profile?
3. What’s your investment duration?
What’s your investment objective?: Are you investing for capital appreciation, i.e. to take risks 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. This is because the stock market is extremely risky and you may lose all your invested capital.
[Read More: How to use profits to determine what stock to buy]
What’s your risk profile?: How much risk are you willing to accept? If your risk tolerance is low, then do not invest in the stock market. Please note: high risk does not automatically translate to higher return.
What’s your investment duration?: All things considered, capital appreciation has a better chance of occurring when you stay invested in the stock market.
So, if you are 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 you are approaching retirement age, do not invest substantially in the stock market, as you have less time and less margin for error with your investment capital.
Once you answer these questions and decide to proceed, we proceed to the next step.
Stage 2: Understand the difference between the Share Price and Intrinsic Value.
With shares, it is important to understand the difference between the market price of a stock and Intrinsic value of a stock.
The Share Price is simply what the stock market offers that share to the public for purchase. The Intrinsic Value is what the share is worth, based on fundamentals—both tangible and intangible.
[Read Also: Why Nigeria is presently a risk-off environment]
The intrinsic value and the share price are never the same; its either the share price is at a discount to the intrinsic value (under-priced), or the share price is at a premium to the intrinsic value (overpriced).
Remember this: So when do you buy shares? You want to buy when the share price is below the intrinsic value of the shares. It’s important to buy shares with a good Margin of Safety, i.e., 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 that N100 equals the present value of all future dividends which the investor will get. To be very simplistic, if you buy Company A’s 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 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 that the share price is still N100. This makes it 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 gets a new huge competitor? The revenue may go down, causing intrinsic value to fall, but share prices is still N100. So I can consider selling.
Let’s summarise: If future earnings are projected to fall, then the share price will eventually fall. This means that the stock is overpriced now, so you should not buy or sell. If future earnings are projected to rise, then the share price will eventually rise; so the stock is under-priced now, and you should buy now, or don’t sell.
Note: we have not discussed how to determine the Fundamental Value of Company A. Let’s do that next week.