An investor determines the intrinsic worth of a stock and buys an undervalued stock based on the premise, that in the long run, the stock market will reflect the fundamentals of the company. In other words, with the passage of time, its market price is expected to equal its intrinsic value. The investor profits on account of his/her ability to identify stocks, that had been trading at a discount to their intrinsic value. Similarly, he sells overvalued stocks since they trade at a premium as compared to their true value.
A speculator assumes calculated risks on the basis of having assessed the direction of the market. Speculation is a highly risky proposition involving above average risks. Moreover, the trade is not based entirely on company fundamentals. Hence, speculation differs from traditional stock investing. It results in volatility and the prudent investor takes advantage of this volatility in stock prices, and picks up undervalued stocks that are expected to appreciate in future.
How to Invest?
Stock investing consist of comparing current stock prices with their intrinsic value, buying stocks trading at a price that is less than their intrinsic value, and selling overvalued stocks. It's evident that the investor has to determine the intrinsic value. The intrinsic value is best determined using fundamental analysis. In addition to fundamental analysis, technical analysis can be used for arriving at conclusions based on historical chart formations and patterns.
Fundamental analysis consists of both quantitative and qualitative analysis. While the latter deals with the quality of corporate governance, brand-name recognition, patents and proprietary technology, the former relies purely on factors that can be quantified. Financial statement analysis is the crux of quantitative analysis. It involves looking at the balance sheet and the income statement to develop an understanding of the company's fundamentals.
The firm's revenue, expenses, assets, and liabilities are used to gain an insight into the company's prospects. The statement of cash flows that focuses on operating, investing, and financing activities is also analyzed to get a true picture of the inflow and outflow of cash. For instance, a company with consistently positive net income but negative operating cash flow does not radiate good health.
Identifying Good Investment
Asset valuation using free cash flow model, dividend discount model, or residual income model will result in the culmination of our efforts to identify a good investment. At the least, a person interested in investing in a company should assess the liquidity, profitability, and financial leverage ratios. Current Ratio, Return on Equity, and Debt-to-Equity are a few of the popular ratios. A careful study of the 10-Ks and the 10-Qs can provide people with the information necessary to assess the financial well-being of the company.
Short selling is a technique that is commonly used by speculators, although investors may use it to hedge their risks. It involves selling borrowed stocks assuming that their price will decline at a later date. In other words, a short sale is undertaken if the stock is perceived to be overvalued. A person indulging in it hopes to return the borrowed stock by buying the share at a lower price. The difference in the selling price and purchase price is the profit, which is earned by undertaking a calculated risk, that could have ruined the speculator in the event of unfavorable price movements.
Since excessive speculation can contribute to an economic bubble and a subsequent stock market crash, a number of restrictions have been placed by the Securities Exchange Commission (SEC) on the size, price, and type of stocks that can be short sold.