How Stock Prices are Set (Stock Market for Beginners*

0:01 Intro ✅ 0:55 Supply & Demand in the Stock Market ✅ 1:08 Order Book (Bids & Asks) ✅ 2:14 Why Stock Prices Rise & Fall (with examples) ✅ 3:03 Intrinsic Value vs. Market Price: What a stock is really worth ✅ 3:32 Importance of Intrinsic Value ✅ 4:13 How Investors Calculate Intrinsic Value ✅ 4:27 Discounted Cash Flow (DCF) ✅ 5:43 Dividend Discount Model (DDM) ✅ 6:12 Asset-Based Valuation ✅ 6:44 Earnings Multiples (like P/E Ratios) ✅ 7:08 Value Investing ✅ 7:31 Stocks Above their Intrinsic Value ✅ 8:51 Is Intrinsic Value useful? ✅

Stock prices are set by supply and demand in the market, driven by investor sentiment, company earnings, and economic factors. Buyers and sellers set bid and ask prices, with transactions occurring when they agree, often facilitated by an "electronic limit order book". Key drivers include company performance, future outlook, and macroeconomic conditions. 

• Supply and Demand: Prices rise when demand exceeds supply and fall when selling pressure is higher.
• The Process: Exchanges use an electronic limit order book, where, behind the scenes, buy orders (bids) and sell orders (asks) are matched.
• Fundamental Factors: Long-term prices are heavily influenced by a company's earnings, assets, and future growth prospects.
• Role of Sentiment: News, sentiment, and market trends can cause short-term fluctuations, often ignoring a company's true "intrinsic value".
• Macroeconomic Impact: Factors like central bank interest rates, economic policies, and inflation also influence general stock price movements. 

For beginners, understanding that individual stocks are riskier and more volatile than diversified funds is crucial.

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The Myth:
Stock prices aren't set by Wall Street elites in closed doors; they are determined in an open marketplace.

The Mechanism: The Order Book

• The constant change in price is a "numerical battle" between buyers and sellers happening in real time.

• Bids: What buyers are willing to pay.

• Asks: What sellers are willing to accept.

• This live list is called the order book (the market's "secret playbook").

The Current Price:

• The price you see on your app is simply the price of the last transaction where a buyer and seller agreed.

• Key takeaway: The price you see is not necessarily the price you would get if you tried to buy or sell right now.

How Prices Move (The Battle Continues):

• When buyers are hyped: They get aggressive and raise their bids to convince sellers to sell. This creates a "bidding war" that pushes the stock price up.

• When sellers are scared: (e.g., due to bad news) They panic and lower their asking prices to find a buyer quickly. This creates a "sale" effect that pushes the stock price down.

Introducing Intrinsic Value:

• Shifts from the mechanical "how" to the philosophical "why" (Why is a stock worth $5 vs $500?).

• Intrinsic Value: The "real" value of a company based on its fundamentals (earnings, assets, growth potential).

• It represents what the company should be worth if you ignore market hype or panic.

The Core Concept:

• Undervalued: Market price is lower than intrinsic value (potential good deal).

• Overvalued: Market price is higher than intrinsic value (potential wait or sell).

• Crucial Note: Intrinsic value is subjective. It is an estimate, not a fact (unlike weighing apples). Different people analyzing the same company will arrive at different numbers.

Intrinsic Value is Subjective:

• It is an estimate, not a hard fact. Different investors calculate different values for the same company.

Common Methods to Calculate Intrinsic Value:

1. Discounted Cash Flow (DCF):

   • Concept: Predicts the future cash a company will generate and then calculates what that future money is worth today.

   • Why discount? Money in the future is worth less than money today due to inflation and risk.

   • Example: $100 earned in 3 years is only worth about $75 today (using a 10% discount rate).

   • Terminal Value: An estimate of the company’s value beyond the forecast period.

   • Result: If the sum of these discounted cash flows equals $10 per share, but the stock is trading at $8, it might be undervalued.

2. Dividend Discount Model:

   • Focuses specifically on the cash paid out to shareholders (dividends).

   • Useful for stable companies (e.g., utility companies) that pay reliable dividends.

   • You estimate future dividend payments, including its growth and discount them back to today’s value.

3. Asset-Based Valuation:

• Adds up everything the company owns (buildings, cash, equipment) and subtracts everything it owes (debt).

• Works well for companies with lots of physical assets (e.g., real estate firms or banks).

Earnings Multiples (P/E Ratio):

• A quicker valuation method based on comparisons.

• How it works: Take the company's earnings per share (profit) and multiply it by the average multiple of similar companies.

• Example: If tech stocks typically trade at 20x earnings and your company earns $5 per share, the intrinsic value might be estimated at $100 per share.

• Drawback: Relies on comparisons, so it is not always accurate.

Value Investors:

• Investors like Warren Buffett swear by intrinsic value.

• Strategy: Buy stocks trading below their intrinsic value (undervalued) and hold them long-term, ignoring short-term market noise.

• Buffett's analogy: "Investing is like buying a farm. You look at its soil and crops, not what the neighbor paid yesterday."

Why Stocks Trade Above Intrinsic Value:

• Not everyone focuses on intrinsic value. Some stocks trade higher than their fundamentals suggest.

• Tesla Example: For years, the stock price seemed too high based on current profits, but investors were buying for future expectations (growth and new technology), not today's numbers.

Why This Happens:

1. Market Sentiment: Excitement about a company or sector can drive prices up, ignoring earnings.

2. Future Expectations: Growth stocks (tech, biotech) often trade high because investors bet on big future profits.

3. External Factors: Low interest rates (2020–2022) made stocks more attractive than bonds, pushing prices up.

Challenges of Intrinsic Value:

• Hard to calculate for certain companies: Startups or biotech firms with no profits yet have an intrinsic value close to zero based on current earnings, yet their stock price may be high because investors are betting on a future breakthrough.

• It's just an estimate: Intrinsic value relies on guesses about the future (growth rates, economic conditions), which can be wrong.

Is Intrinsic Value Useful?

• Yes, for value investors: It helps find undervalued stocks (buying at a discount). Works great for stable companies like Coca-Cola or Walmart where earnings and assets are clear.

• Less useful for growth investors: They focus less on current intrinsic value and more on future potential.

• Market irrationality: The market can ignore intrinsic value for years—it can stay "irrational longer than you might expect."

Final Reminders:

• Intrinsic value is a useful tool, but it is not perfect and doesn't always work.

• Always do your own research or talk to a financial adviser.

• Investing involves risk; you could lose money.

Growth in profits have LITTLE role in determining intrinsic value.

 

Growth in profits have LITTLE role in determining intrinsic value.

https://myinvestingnotes.blogspot.com/2010/04/growth-in-profits-have-little-role-in.html

Growth in profits have LITTLE role in determining intrinsic value.  It is the amount of capital used that will determine value.  The lower the capital used to achieve a certain level of growth, the higher the intrinsic value.

Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraph will surely make the reader a much better investor.

Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value.

There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines.

Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.

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 It captures a fundamental, yet often misunderstood, principle of value investing. Let's break it down, discuss its implications, and summarize.

Core Thesis: Growth is Not a Free Good

The central argument is a direct challenge to conventional market thinking, which often equates "growth" with "value." The passage asserts that growth in profits is not inherently valuable. It only becomes valuable under a specific condition: when the capital required to generate that growth earns a return above the company's cost of capital.

• Growth that Destroys Value: If a company (or an entire industry) must invest massive amounts of capital at low returns (e.g., 4%) to grow profits, but its cost of capital is 8%, it is destroying shareholder wealth with every new dollar invested. The profit number goes up, but the economic value per share goes down.

• Growth that Creates Value: A company that can grow profits by reinvesting minimal capital at high returns (e.g., 25% on capital) is a value-creating machine. Software companies, certain branded consumer goods firms, and platforms with network effects often exemplify this.

Key Concepts Explained

1. "The amount of capital used will determine value."

   • This refers to the Return on Invested Capital (ROIC). Value is a function of cash flows, and high ROIC means the business generates more cash flow per dollar of capital locked up in the business. A business with a 30% ROIC is far more valuable than one with a 10% ROIC, even with identical current profits, because its future profit growth will require less dilution or debt.

2. "Each dollar used to finance the growth creates over a dollar of long-term market value."

   • This is the value creation test. The "dollar of long-term market value" is the present value of all future cash flows that dollar of investment will generate. If that present value exceeds $1, management has created value. This is directly linked to investing at a spread above the cost of capital.

3. The Example of US Airlines:

   • This is a classic case. The industry has seen consistent growth in passenger traffic and, at times, profits. However, it is fiercely competitive, requires enormous ongoing capital expenditures (planes, maintenance, gates), and has historically earned returns below its cost of capital. The net effect over decades has been wealth destruction for equity investors, despite being a vital and growing service.

Commentary and Nuance

• Echoes of Great Investors: This philosophy is pure Warren Buffett (inspired by his mentors Ben Graham and Charlie Munger) and Michael Mauboussin. Buffett famously said, "The best business is one that can employ large amounts of incremental capital at very high rates of return." He also warned about "the institutional imperative" that pushes managers to pursue growth at any cost, even value-destructive growth.

• Link to "Economic Moats": A business's ability to reinvest at high rates over time is protected by its competitive advantage or "moat." Wide-moat businesses (strong brands, patents, network effects) can sustain high ROIC as they grow. No moat means competition will quickly drive returns down toward the cost of capital.

• The Investor's Practical Takeaway: The passage instructs investors to look beyond the headline "profit growth" figure.

  1. Primary Metric: Focus on Return on Capital Employed (ROCE) or ROIC.

  2. Compare: Weigh the ROIC against the company's estimated Weighted Average Cost of Capital (WACC).

  3. The Rule: Seek companies where ROIC > WACC, and where this spread is sustainable. Be deeply skeptical of high-growth companies with low or declining ROIC.

  4. Sector Selection: As advised, be wary of sectors prone to value-destructive growth cycles—airlines, traditional telecom, capital-intensive manufacturing—unless there is a clear, structural shift toward discipline and higher returns.

Summary

In essence, the passage makes a critical distinction:

• Naive View: Growth in Profits → Higher Intrinsic Value.

• Sophisticated View: Growth in Profits at High Returns on Capital → Higher Intrinsic Value. Growth in Profits at Low Returns on Capital → Can Actually Destroy Intrinsic Value.

The ultimate determinant of value is not growth itself, but the quality of that growth as measured by the return on the capital required to achieve it. An investor who internalizes this shifts their focus from the top-line growth story to the economics of the business model, thereby avoiding value traps disguised as growth stories and identifying truly exceptional compounding machines. This is, indeed, what makes a "much better investor."

Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.

Wednesday, 31 March 2010

Buffett (1980): The true value is determined by the intrinsic value of the company and not the dividends.

https://myinvestingnotes.blogspot.com/2010/03/buffett-true-value-is-determined-by.html

Warren Buffett in his 1980 letter to the shareholders of Berks

hire Hathaway:

"The value to Berkshire Hathaway of retained earnings is not determined by whether we own 100%, 50%, 20% or 1% of the businesses in which they reside. Rather, the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage."

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Buffett’s thinking from that 1980 letter.

Let’s break down and expand upon the key ideas you’ve highlighted:

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1. Intrinsic Value vs. Dividends in Accounting

Buffett was criticizing the accounting convention that focused on dividends received from partially owned companies as the measure of value for the owning company.
He argued that the real worth to Berkshire wasn’t the dividend payout, but the proportionate share of the underlying business’s intrinsic value — regardless of whether those earnings were paid out or retained.

Your Indian example — valuing M&M based only on dividends from Tech Mahindra, rather than 20% of Tech Mahindra’s intrinsic value — perfectly illustrates the flawed accounting viewpoint.
If Tech Mahindra reinvests its earnings profitably, the retained earnings compound and increase the intrinsic value of M&M’s stake far beyond the dividends received.
Accounting rules at the time (and to a large extent still today) fail to capture this unless ownership exceeds a certain threshold (e.g., consolidation or equity method with impairment tests, but still not intrinsic-value based).

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2. Retained Earnings: Value Depends on Use

Buffett’s core point:

“The value of retained earnings is determined by the use to which they are put and the subsequent level of earnings produced.”

This means it’s not retention itself that creates value, but the return on reinvested capital. If a business can reinvest earnings at high rates of return, retaining earnings adds more value than paying dividends.
If it can’t find good reinvestment opportunities, returning capital to shareholders (via dividends or buybacks) is better.

For partial ownership, even if you don’t control the capital allocation decisions, if the investee company reinvests earnings well, your share of its value grows without you receiving cash dividends.
That’s why Berkshire’s holdings in companies like Coca-Cola or See’s Candies were worth far more than the dividends indicated — because retained earnings were deployed into high-return operations.

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3. Buybacks at a Discount to Intrinsic Value

The second quote contrasts corporate acquisitions (often full-price or overpay in competitive bidding) with stock buybacks in the open market (where shares can sometimes be bought far below intrinsic value).

Key takeaways:

• Acquisition market = auction between corporations → often pays premium to intrinsic value.

• Stock market = sometimes an auction where sellers panic → can buy parts of a business at a discount.

Buffett loves buybacks when:

1. The stock trades below intrinsic value.

2. The company has excess cash and no better investment opportunities.

Buybacks increase per-share intrinsic value by reducing shares outstanding, effectively giving remaining shareholders a larger claim on future earnings at a bargain price.

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4. Relevance Today

These principles remain central to value investing:

• Look-through earnings: When evaluating holdings, include your share of undistributed earnings of subsidiaries/associates if they are reinvested well.

• Capital allocation priority:

  1. Reinvest in high-return projects.

  2. Acquire other businesses at fair prices.

  3. Buy back stock when cheap.

  4. Pay dividends if no better use.

The accounting standards (e.g., IFRS 9, ASC 323) still don’t fully reflect “look-through” intrinsic value for minority holdings — they focus on dividends, fair value changes, or equity-accounted earnings, but not necessarily the full economic value of retained earnings compounding inside the investee.

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5. Buffett’s Broader Philosophy

The 1980 letter segment you’re discussing fits into Buffett’s larger framework:

• Own businesses, not stocks → value comes from underlying business performance.

• Mr. Market offers opportunities to buy/sell pieces of businesses at irrational prices.

• Management’s job is to increase per-share intrinsic value over time, not to cater to short-term stock prices.

By ignoring dividends as the sole measure of value from investments and focusing on the growth in intrinsic value, Buffett built Berkshire’s worth far beyond what dividend-based accounting would suggest.

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SUMMARY

Here is a summary of the article's key points:

Core Argument

Warren Buffett, in his 1980 letter, argues that the true economic value of a company's stake in another business is not determined by the dividends it receives, but by its share of the intrinsic value of the underlying business. Accounting standards that focus on dividend income are misleading.

Main Points

1. Intrinsic Value Over Dividends:

   • If Company A owns 20% of Company B, the stake should be valued as 20% of Company B's intrinsic value, not just 20% of the dividends paid out. This is because retained earnings reinvested into the business can create far more long-term value.

   • Example: Valuing M&M based only on the dividends from its stake in Tech Mahindra would be incorrect; one must value its 20% ownership of Tech Mahindra itself.

2. Value of Retained Earnings:

   • The worth of retained earnings depends entirely on how effectively they are reinvested. If a business can reinvest earnings at a high rate of return, retaining them creates more value than paying them out as dividends.

3. Buybacks vs. Acquisitions:

   • Acquisitions often occur in a competitive auction, forcing acquirers to pay a "full" or inflated price.

   • Stock Buybacks, however, allow a company to buy parts of its own business in the open market, often at a significant discount to intrinsic value, especially during market panics.

   • Buffett strongly advocates for buybacks when a company's stock is trading below its intrinsic value, as it is the most efficient use of capital to increase per-share value for remaining shareholders.

Conclusion

Buffett’s philosophy centers on economic reality over accounting convention. A value investor should focus on the growth of intrinsic value from reinvested earnings and take advantage of market irrationality to buy ownership stakes at a discount.