Buying and selling are natural opposites. The reasons for buying a stock and selling a stock, often, are mirror images as well. Intuitively, it feels right. How do we give form to an intuition? More accurately, how do we decide when to buy or when to sell?
Well, we often read about valuations. Some analysts might have a SELL call saying the stock is overvalued. At the same time, some analysts might have a BUY call saying the stock is undervalued. Then, there are some analysts who might say the stock is fully valued and have a HOLD call.
What can we take away from this? Valuation is subjective! Anyone who tells us it isn't doesn't know what he is talking about or does he?
There is a lot of literature on valuation techniques. If we do a search online, we will know that this is true.
So, which valuation technique to use? This is already an exercise in subjectivity. Then, each valuation technique could require us to make certain assumptions which is another exercise in subjectivity. Of course, we are only talking about bottom up approaches here.
What about a top down approach? This requires a grasp of economics, market conditions and industry specific trends, just to name a few things that come to mind. Reminder: the assumption that consumers have perfect knowledge when we discuss certain economic concepts only works in a classroom environment.
If you have zero or very little knowledge of economics and business, you might want to teach yourself by reading these books:
|Timeless. US$17.61 a copy.|
|This book is heavy reading and somewhat pricey.|
Click on the image and search for
"Understanding Michael Porter:
The Essential Guide to Competition and Strategy".
This is easier reading and much cheaper.
So, it is not surprising that experts could have differing views all the time. They could make different assumptions in their quantitative approaches and they could have different opinions on the qualitative aspects of businesses which require judgement calls. If experts have such a hard time, what can retail investors like us do?
Value investors are often looking to buy stocks at half of their intrinsic values. If a stock that has an intrinsic value of $1.00 is selling for $0.50, simply, it is a buy. Now, if a stock has an intrinsic value of $1.00 and is trading at $2.00, what do we do? You tell me.
The question is, therefore, how do value investors determine intrinsic value. They use an approach called Discounted Cash Flow (DCF). I shan't go into details here because there are many free online resources that will teach us what is DCF and we will realise that we could come up with different intrinsic values for the same stock. Why different values? We could make more conservative or more aggressive assumptions and values will change.
To understand cash flow, we will have to look at a company's cash flow statement. I blogged about it before and you can read it: here. If you want to read up on valuation using DCF, you could go to Wikipedia: Valuation using DCF.
Some people look at PER, NAV/share and NTA/share of a stock to see if it is undervalued or overvalued. Some might argue that if a stock has a very low PE and trades at a discount to NAV, it is undervalued. Well, it could be. However, if by doing a comparison, we find that other companies in the same industry have similar ratios, then, perhaps, it is just the industry norm.
I remember many years ago, I made a very good trade in Singland. At that time, most of the big name property counters rose in value but Singland was still stuck in a rut. I did a comparison of its ratios against its peers and found it was relatively cheap or, if you like, undervalued. I bought and within a couple of weeks, its price shot up. I cannot remember exactly now but it was quite a handsome capital gain. Singland was a laggard. I did not know if it was absolutely undervalued but it was relatively undervalued.
Different industries have different characteristics. Some are cyclical like the property market. So, given changing market realities, property stocks could see their share price fluctuating as well because their earnings are impacted negatively during down cycles and positively during up cycles. The same could be said of shipping stocks.
If you want to read up on how we could possibly make generalisations about stocks and have an inkling as to their characteristics, you might want to read books which I blogged about before by Pat Dorsey (here) and Peter Lynch (here and here).
By now, if you are still with me, good on you because I am not done yet. We are soldiering on in part 2.
Read part 2:
When to BUY, HOLD or SELL? (Part 2)