People gain from stock market because stock market does not fully reflect a stock’s “real” value. After all, why would we all are doing stock market analysis if the stock prices were always correct? In financial jargon, this true value is known as the intrinsic value.
For example, let’s say that a company’s stock was trading at $40. After doing extensive homework on the company, you determine that it really is worth $50. In other words, you determine the intrinsic value of the firm to be $50. This is clearly relevant because an investor wants to buy stocks that are trading at prices significantly below their estimated intrinsic value.
The comparison between market price and intrinsic value helps to make decisions regarding the buying or selling of a particular share.
The following notes show the comparison, decision and reason:
1 Market price < Intrinsic value
e.g. $ 50 < $ 60
- Under- priced
- Buy
- Because the market price increases to meet the value and we can gain from the price rise.
2 Market price > Intrinsic value
e.g. $ 40 > $ 30
- Over- priced
- Sell
- Because the market price falls to meet its value and we can avoid the loss by selling the share now.
3 Market price = Intrinsic value Correctly
e.g. $ 20 = $ 20 priced
- No action
- Because it is correctly priced and the price is not expected to change.
- Therefore there is no profit likely to be made from buying or selling the share.
4 Market price almost equal to Intrinsic value
e.g. $ 40 is almost equal to $ 42- No action
- Because the difference in the value and price can not offset the transaction cost and we can incur losses.
The big unknowns are:
1) You don’t know if your estimate of intrinsic value is correct; and
2) You don’t know how long it will take for the intrinsic value to be reflected in the marketplace.
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