Investing Theory

Unraveling the True Mechanics of Stock Investing

October 12, 2023

Investing in stocks compared to investing in other assets seems quite tempting, not only in terms of achievable returns, but primarily due to the ability to assess the real value of a given company.

The price of a single share on the stock exchange is nothing more than a (partial) value of a piece of a company. By multiplying the price of a single share by the number of shares in circulation, we obtain the company’s market capitalization, or its stock market value.

The company’s market capitalization is the amount an investor would need to have to buy all the shares of that particular company from the stock exchange at a specific moment. Let’s assume that a company’s market capitalization is 100 million and there is a bold investor who decides to buy all the shares from the market, as they intend to carry out a so-called hostile takeover. Let’s also assume that they succeed.

But before that, let’s consider why anyone would want to buy all the shares from the market.

How to Know How Much the Company is Worth?

Firstly, the investor may have determined that the real value of the assets held by the company exceeds the amount of 100 million. The company’s assets may include production lines, buildings, patents, licenses, vehicle fleets, goods already produced but not yet sold, cash on hand, and all other tangible items that together make up the book value of the enterprise.

If the investor calculated (or simply checked in the financial statement) that the actual book value of the company is 150 million, then it was a very good idea to buy all its shares for a total amount of 100 million, because now the investor can hire a liquidator and sell the company’s assets to receive 150 million in cash.

This is, of course, a considerable simplification but clearly illustrates the reason why a trader would be interested in buying shares of a given company. A situation where the company’s market capitalization (its current market value) is lower than the value of its real assets (the company’s book value) may present an attractive investment opportunity.

In the real world, such situations rarely last for a long time in the case of good companies, but they occur quite frequently in short periods. This is because the current share price on the stock exchange, or the company's market capitalization, is not determined by accountants, financial directors, or even any rational factors, but – frankly – by the crowd.

The Difference Between Value and Price

The share price at a given moment is shaped by the general pool of investors, consisting of pension funds, hedge funds, investment banks, and individual clients who have entrusted their money to their funds or trade on the stock exchange on their own account.

The crowd is subject to emotions and sentiment, and sometimes even panics. The crowd can bring the stock market price of shares to absurdly low levels without any specific reason. In a world of almost perfect correlation, there are situations where good shares will fall simply because the entire market is falling. Often this has nothing to do with the condition of the specific company.

Emotional investors visualization.

If a company announces a 3% decrease in profits, its shares may fall by 30% within a week, although such a decline in the company’s value is not justified, because – according to the rules of mathematics – if we currently get 3% less profit for one share, the value of the share should also fall by 3%. Not at all.

The crowd relies on sentiment. When an individual sees the crowd running in a certain direction, they run with it. That’s why the stock price on the stock exchange in shorter time intervals can be very detached from the real value of the stock, which can make the stock market seem somewhat frustrating for novice investors.

However, from a professional investor’s perspective, there is nothing better in the market, because only in such absurd situations does a sensible trader have a chance to buy good shares at a decent price.

The Market is Not an Efficient Machine

If the market were efficient – meaning it honestly and adequately priced all shares at all times – we would have nothing to look for on the stock exchange because there would be no such thing as a “bargain”. The only way to make money here is to buy low and sell high. In other words, one must look for opportunities on the stock exchange.

Therefore, if all traders behaved one hundred percent rationally and always priced shares fairly, investment opportunities would never arise.

In conclusion: market inefficiency and its irrational behavior in the short term (weeks or months), although often incredibly annoying, actually allow experienced investors who know what they are doing and can keep their cool in the face of the crowd to make money.

The remaining question is how long this kind of situation, where a company’s market capitalization deviates from its book value, will persist in the market. Well, it can be a week, a month, or a year. Everything depends on sentiment – the attitude toward the stock market itself.

However, if everything is fine with the company and we are not dealing with a company on the verge of bankruptcy, investors will sooner or later be tempted by its shares. A situation where physical assets worth 150 million can be bought for 100 million certainly represents an interesting opportunity.

Summing Up…

When investors’ optimism about the market begins to grow again, the stock prices that have been undervalued compared to their intrinsic value will start to rise with it. There is no magic in this, and no mathematical indicators are needed. It is an age-old law of trade – if something is good and cheap, it is worth buying to sell later at a higher price.

The whole art is to learn to analyze companies in such a way that one can assess whether shares are cheap or expensive at a given moment, and more importantly, whether they are even worth buying at all.

Start your free trial

And save 97% time spent on stock analysis!

Similar posts

Start your 7-day free trial

Automate your research and quickly find undervalued stocks.
Get Started →
No credit card required
Cancel anytime