Dont chase pinpoint precision in computing optimum share price

Written by P Saravanan | Updated: Jun 3 2014, 16:39pm hrs
InvestorThe investor should make sound investing decisions based on reasonable fundamental values.
The most common question equity market investors face is when to buy, sell or hold. Further, it is approached differently by investors and speculators. Here we discuss a reliable method that investors can use when attempting to make these decisions.

Figuring true worth of cos

Investing in equities requires diligence and a comprehensive understanding of the true worth of the business. It is essential for you to have a reasonable idea of the business you are contemplating buying into. However, there is additional complexity in identifying the true worth. While attempting to arrive at the value of a business, the four most common expressions are: intrinsic value, fair value, fundamental value and true worth.

Though not synonyms, they are often used as if they were. Nevertheless, the four terms do share a common objective. Regardless of the name, the idea is to quantify an optimum price that can help arrive at a sound investing decision. And even though not exact synonyms, they are all close enough to be of practical value.

In other words, all these expressions are focused on calculating what the business is actually worth (of the shares you either own or propose to own) within a reasonable range. Therefore, it boils down to having an intelligent framework to make sound investing decisions.

Arriving at intrinsic value

A common mistake investors make while attempting to calculate intrinsic value is being too strict with the application of the mathematical formulae suggested in investing books. Each formula has its advantages and disadvantages. In fact, a vast majority of these were originally developed for evaluation of companies tangible fixed assets, and not for companies in todays service-based economies where balance sheets include a significant amount of intangible assets.

Hence, applying a precise calculation of the value of intangible assets, such as intellectual property, patents, trademarks, copyrights, business methodologies, brand recognition and goodwill, are much more challenging than valuing a factory building or plant and machinery, equipment, etc. Intangible assets, like tangible and fixed assets, do produce significant cash flows for many service and technology-based companies. Therefore, even though they are more difficult to value accurately, they do contribute significantly to the true value of a business.

While computing the intrinsic value may not be an assured way of mitigating the losses in your portfolio, it does provide a clearer indication of a company's financial health, which is vital when picking stocks for the long term.

What matters is that the investor should make sound investing decisions based on reasonable fundamental values.

Similarly, investors also need to recognise that the calculations of a shares values can never be perfectly precise. At any rate, they just need to be accurate enough to provide us the opportunity to successfully grow our portfolios and create wealth.

The writer is associate professor, finance and accounting, IIMShillong

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