While investing in stocks, a very basic concept is to understand the value of a stock, and whether it is worth investing in the stock.
The stock prices observed in the market are called the market prices of the stocks.
Based on fundamental analysis and using equity valuation model, an investor will try to calculate the fair value of the stock, also called the intrinsic value. This is the value that the investor feels that the stock should actually be trading at.
Let’s say that an investor is analyzing ABC stock. The current market price of ABC stock is $90 per share. The investor does a lot of research and finally arrives at an intrinsic value of $100. According to the investor, the ABC stock should actually be selling at $100 based on its current fundamentals and under certain assumptions made by the investor. Since the stock is currently selling at $90, the stock is undervalued according to the investor, and its value should rise up to its intrinsic value. In such a case, the investor will buy the stock at its current price of $90 expecting the price to rise.
If Intrinsic Value > Market Price, the stock is undervalued. The investor will want to buy the stock.
If Intrinsic Value = Market Price, the stock is fairly valued. The investor is neutral about the stock price.
If Intrinsic Value < Market Price, the stock is overvalued, and investor expects its price to fall.
One must note that the market itself is supposed to price the stocks quite fairly, however due to asymmetric flow of information, the market price may not reflect all the information available. An investor who is able to utilize the information available more efficiently than the market can take advantage of the mispricing and make abnormal profits.
The key here is how well the investor is able to calculate the value of the stock, and how true are the assumptions made by him while valuing the stock.
In the next article we will explore the valuation models that are commonly used to value stocks.