5 Investment concepts

The whole purpose of valuation is to find out the approximate price at which you can buy a stock. And, if you do that, the return you deserve for taking that risk .

For this, there are some concepts that you should be aware of. They are –

  • Concept 1.

Intrinsic value – A notional value of the stock based on certain calculations. A price at which you feel the share is worth buying. Read More

  • Concept 2.

Book value – what a company is worth recordically. It’s computed from the balance sheet by adding up all the assets and deducting from it the total liabilities of the company.Read More

  • Concept 3.

Margin of safety – A general theory of safety applicable in all walks of life-not only in finance. For example- If you are driving a car at 100 mph, would you drive it so close to the vehicle in front? No. You’ll leave a distance. Why? Because, you need a margin or a space to break your car to safety just in case the driver in front commits an error. Faster you drive, more distance or margin of safety you need.

Similar is the case with shares. Unforeseen events can ruin a company or errors are possible in your calculations and assumptions. So you’d try to buy a share only at a rate that’s 30 or 40% below your ‘intrinsic value’ calculations- just in case…. The more risk averse you are, more Margin you need. Iconic investor Warren buffet recommends a margin of more than 2/3rds or 66% from intrinsic value.

  • Concept 4.

Risk premium – The minimum amount of return that an investor expects to park his cash in risky assets like stocks instead of risk free deposits. This is the difference between the average return of stock markets and return from risk free investments.

  • Concept 5.

Cost of equity – A company gets money to do business in two ways – loans and capital contribution from shareholders. Loans carry interest. So, the cost of availing loan is known. Equity capital contributors have to be compensated by the company by giving them returns.What is the rate of return to be given to equity investors? There is no specific rate of return. The returns given by the company should be sufficient to compensate the risk that the investors have taken in giving money to the company. This rate of return is called the cost of equity.

The cost of equity is directly related to risk. If the shares of a company are considered risky, investors would demand more return to park their funds in that company instead of a safer one.

We take up all these concepts in our next posts.

You may like these posts:

  1. What are the stages in investment process?
  2. Understanding ROE & ROCE.
  3. Which investment is best for you?

4 Responses to “5 Investment concepts”

Mansoor

January 24, 2012 at 8:00 am

Short and crisp article, very nice to know these. Isn’t book value with margin of safety similar to intrinsic value, not by calculation but by concept to shortlist a stock? What I mean is, if you know that a stock is fundamentally good, and the you could decide on buying that stock if the market price is below book value with a margin of safety?

J Victor

January 24, 2012 at 12:20 pm

Book value x margin of safety is not intrinsic value.

I’ll explain why:

Intrinsic value is derived after considering all the factors that add up to a company’s value which includes:

1. Book value.
2. Intangible assets (like goodwill, intellectual property, brand value etc.)
3. Future prospects and expected profitability
4. Quality of the management
5. Financial fundamentals
6. Estimate of Risk factors ( of the industry and the company)

So, if you just reduce item 1 (book value) by a margin of safety you don’t arrive at the intrinsic value. What you arrive at is called ‘reduced book value’. Theoretically, you could make a profit from any company if you buy it at reduced book value .How? Since you get all the assets at less than what is in books, just buy the entire company and liquidate it off !!

But in real life, we are here to buy just a tiny fraction of a ‘promising’ company. A company whose future is bright.

When you add items 2 to 6 to book value, you are trying to reduce the ‘bright future’ of the company in TODAY’s monetary terms. (Most values would be a best guess or estimates ). When you do that, what you arrive at is called intrinsic value. Hence intrinsic value is an estimate rather than an absolute value.

To say it from another angle, intrinsic value is the discounted value of future cash that could be generated by the company. It keeps changing as the interest rate and future outlook of the business changes.

Mansoor

January 24, 2012 at 11:24 pm

Thanks for taking time to explain that Victor, appreciate it. It makes sense now since all the fundamentally good stocks are always at or above P/BV of 2, they are available at a market price of more than twice their book value. I just saw a new article in your blog called “Concept 1: Intrinsic Value”, I will read that to understand the concept better. Thanks again for all your efforts.

Ub

January 25, 2012 at 11:56 am

I am really satisfied with this posting that you have given us. Thank you and looking for more posts

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