How To Pick Stocks (Part 1): Assessing Value

Sep 11, 09 How To Pick Stocks (Part 1): Assessing Value
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“Playing” the stock market is no game.  As one of the greatest engines of wealth creation the world has ever seen, understanding how the stock market works is critical to understanding modern economics and specifically, modern capitalism.  Nonetheless, the business of buying, selling, and trading stocks is still a complicated enterprise for many Americans.  Deciding which stocks are worthy of investment is the basis of stock analysis.  Determining value is something that we do every day.  Understanding how to determine the value of stocks is one of the most fundamental, yet difficult, aspects of understanding the stock market.

Intrinsic Value

Before deciding to invest in a company or product, you must ascertain its intrinsic value.  There a many complicated matrices that are supposed to help determine intrinsic value.  However, at its core, intrinsic value is the sum total of a company’s future profits.  Stock worth is established by a business’s fundamental profitability.

Why Do Stock Values Fluctuate

Oddly enough, many stock transactions are not based on a rational model of intrinsic value.  Rather, the goal becomes to sell the stock for a higher price than what was paid for it.  This idea is also labeled “Greater Fool Theory” because stock profit is determined by whether it can be sold.  This underlies two basic ideas about stock trading.  Technical traders rely more on market trends and short-term data, while fundamental investors have a more long-term strategy guided by intrinsic value.

Before deciding that one strategy is essentially better than another one, it is important to realize how hard it is to forecast the future.  Predicting a company’s value well into the future is a difficult task because there a numerous variables that actually define and influence profitability.  In future installments, we will discuss the merits of both of fundamental investing and technical investing, as well as gaining some insight into which variables are the most important for ascertaining true value.

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