Things you really need to understand before you start buying stocks

After running this blog for almost a year, I realized I haven’t dedicated too many articles for investment beginners. I will drill down the very basic of stock (equity) investing. Please mind that I am assuming the readers are interested in investing (holding the stocks for longer than a year) rather than trading (buying and selling stocks in a short span of time).  Also, I will keep the concepts as simple as possible so please bear with me if some details seem lacking.

What is stock?

Simply speaking, stock is a piece of a company. Buying a stock is equivalent of buying a piece of a company.  For some, it might be difficult to grasp this concept. If so, think of it like a pie. A company can be divided into pieces like a pie and people can buy/sell in a market.

sweets_applepie.png

What is value of a stock?

As mentioned before, a stock is a piece of a company.
[The value of stock = Total value of company / # of stocks of the company outstanding]
If the total value of a company is worth $100M and there are 50M shares, each share should worth $2.

This is equivalent of
[The value of a piece of pie = Total value of whole pie / # of pieces]
If the whole pie is worth $10 and it’s divided into 5 pieces, each piece should worth $2.

What is the value of a company, then?

The fundamental value of a company is mainly composed of two factors:

  1. How much cash can a company generate if it sold everything it owns today?
  2. How much cash can a company generate in future by running the business?

Putting aside the time value of money (insert link), the sum of above two is the value of a company. In terms of the pie example, as a company’s cash generating capacity gets larger, the pie (value) becomes larger as well.

Why and when do investors buy a stock?

Investors buy (or should be buying) a stock when they believe the stock price is lower than the value of the stock.

Simply speaking, finding a good stock is similar to finding a bargain while shopping. For example, say you found $80 authentic Chanel bag at a flea market with mint condition. You know the price of the bag should be at least $800 even in a second-hand market. In such case, the only rational decision would be to buy the bag, own it (or give it to your wife) or resell it at a higher price to make money.

You may not find such a cheap Chanel bag (I wish, my wife keeps asking me to buy one) but similar bargains can be found occasionally in stock markets. Some stocks might be priced too low as some people might underestimate the cash generating capacity of a company. Investors buy such stock, hold it and sell it once other people realize the true value (cash generating capacity) of the company.

Summary & Conclusion

You should follow the decision process below when purchasing a stock:

  1. Determine the value of a company by analyzing the company’s financial statement
    (especially the cash flow statement), the company’s business model, the company’s growth strategy, etc.
  2. Divide the value of a company by number of shares (stocks) outstanding. This gives us the value of the company’s stock.
  3. Compare the value of the stock and the price of the stock.
  4. If the price is significantly less than the value, it’s a bargain. You should buy the stock.

Of course, determining the value of a company is not easy and requires some financial knowledge and rigorous analysis. I’m not going into the details of valuation in this article to focus on the fundamental concepts, however, if you would like to learn more, you should subscribe to the blog and stay tuned for updates!