Investors are often lured into investing merely because of rising stock prices and investor success stories, but is there something they are missing about the true meaning of stock traded price? More often than not, actual stock price is merely a reflection of supply and demand, a measure of how much the average investor is willing to pay to acquire that stock. A stock’s price does not in any way accurately reflect the underlying company’s assets and net worth! In fact, it may be way off its actual, intrinsic value. This is a huge misconception among investors, they completely confuse trading price with intrinsic value… most of the time, it is the company assets that create that false impression that the company is rich and therefore the stock price is well justified, and expected to rise further.
Case in point: BP stock prices, the stock has an intrinsic value of $60, but it has recently traded much lower:
What this means, is that BP is a still a great stock to hold in your 401K, or in any long term objective investment, with an at least 5 years plan. Sooner or later the stock will trade back up to the $60 level. We can see however that the oil spill accident caused the stock price to drop to as low as $27.
Stock Prices are influenced in the near term by supply and demand, more specifically, on a 3 to 6 month outlook, a stock at Wall Street will trade according to how traders view company earnings, and not intrinsic value. This means that even extremely underpriced stocks that have huge intrinsic values can decline big over the next 3 to 6 months, just because the company’s earnings missed analysts forecast by few pennies! I know it doesn’t make logic sense, but that’s how the stock market really works in the short to medium term. In the long run however, stock prices catch up with their intrinsic values, stocks that are bubbles (Have risen way above their intrinsic values), are the ones that will absolutely collapse when the next seasonal market decline occurs…
So how can one eliminate all risk about stock prices?
Unfortunately, you can’t remove all the risk, even if you do objective fundamental analysis on a stock, and figure out its intrinsic value, there’s nothing there to say that the very fundamental data you worked on are legitimate! Sometimes corrupted accountants cook their books, hiding away company debts and liabilities while inflating profits… remember Worldcom and Enron? They had excellent looking intrinsic value! Luckily though, these are the exception to the rule, and if you invest carefully over a diverse portfolio of stocks with strong intrinsic values to back their stock prices, then you can dramatically improve your odds of achieving a high return investment. The savvy investor will always look at company earnings, and overall cash flow and profitability through the years, this is the best way to start analyzing stocks, and it can reveal right away which stocks are to be avoided, and which are worth investigating further to find the best of the best among them.