(ak) + (ai)

One of the important qualities an investor must posses is the ability to price the stock he is buying. One must not be overwhelmed by the voices of the market as the market can sometimes be irrationally bullish or foolishly bearish.

Whenever the market is irrationally greedy, prices will tend to be overvalued and investor will have to pay a premium for his investments. On contrast whenever the market is foolishly bearish investors can hope to find stocks at a discount.

Now how does one tell when is the stock over or undervalued? To do so one must know the difference between book value, intrinsic value and the market price. What investors should focus on is the intrinsic value of the stock against the value that he will be paying to own the stock; which in most cases is the market price.

What is intrinsic value?

The definition of intrinsic value is the discounted value of the cash that can be taken out of a business during it’s remaining life.

Wow! That’s a handful to digest. What is the meaning of it? Please allow me to enlighten you with a simili.

Imagine a student finishing high school and about to enter into college. The cost of the college education in term of fees, livelihood and opportunity cost for studying instead of working is the book value.

The intrinsic value is the salary the student might earn upon graduation and through out his working life against his salary had he remain uneducated then to be discounted at an appropriate interest rate back to graduation day.

Based on this simili it is clear that understanding the book value of a company is generally easy. Simply take the valuenin the books of the company in terms of assets, cash in banks, etc. But for the intrinsic value it is as much art as it is science. Two investors presented with the same facts may come, and in most instances will, come up with the different intrinsic values. Hereby lies the skill of an investor. To determine the intrinsic value of an investment.

Whatever it is, it is crucial for the investor to realize that the book value has, at time, no relation with the intrinsic value. But most important, the market value has nothing to do with the prices dictated by market forces. In fact the jittery market is the reason why investors who understand the difference of all these profit and beats the market.