Investors determine the market price of a stock. The price depends on three things: The attractiveness of the company’s business, its industry, and the stock in general. The price does not always have anything to do with the true value of the business itself. The cheapness or expensiveness of a stock’s price is directly proportional to the future cash flows generated by the business. If the cash flows are greater than expected, the price is cheap. If the cash flows are less than expected, the price is expensive. Fisher never explained how he determined the true value.
All significant price changes in individual stocks relative to others occur when large numbers of investors change their perceptions of the company or its shares. Market prices change more because of what investors believe will happen than because of what actually happens. The market price fluctuates according to perceptions, and the true value of a stock can differ from reality for years. Sooner or later, false valuation levels will be broken and the price will correspond to true value, at least for a while. False prices arise from short-term psychological factors when investors become excited or depressed about a company, industry, or stock market.
A high P/E ratio does not directly indicate that the shares are expensive. Higher P/E ratios for companies that have increased their earnings and turnover over a long period of time can indicate their ability to increase earnings far into the future. An investor needs to understand the company and its future. This will allow them to draw conclusions about the correct value of the shares. A company's P/E ratio will likely be high in 5-10 years if the company is continuously developing new sources of income, its cost-efficiency, and its industry allows for positive earnings development. The shares of such companies take the future into account in their prices less than investors believe. Therefore, the prices of shares may seem high at first glance, even though they are inexpensive after valuation.
No one can determine the exact value. Conclusions can be drawn about companies that provide sufficient accuracy. Shares of companies that are rapidly growing their earnings and revenue can have high P/E ratios. Determining their true value is difficult because the current growth rate is less important than how long the growth will continue. The further you try to predict, the more likely you are to be wrong. Fisher offers investors excellent return opportunities, as shares of such companies can be purchased at a price that is no more than 25-30% of their true value.
Fisher defined the risk of stocks based on the quality of the companies' business and the general valuation level. He examined quality using his fifteen points and the general valuation level using market expectations, which was reflected in the shares' P/E ratio. He examined the latter using the last result. Fisher found the lowest risk and most sensible investment target in stocks that meet the quality criteria, but are undervalued by P/E ratios compared to the quality of the business. The second most sensible investment targets are found when the quality criteria are met and the valuation level reflects them.
The third group is companies that meet the quality criteria, but have become so attractive investment targets in the eyes of investors that they are willing to pay almost anything for them. Fisher recommends keeping these companies in the portfolio, but not buying them. In his opinion, if the business is truly high-quality, its development will soon prove that the current prices are reasonable.
Meeting the fifteen points is rare for companies, so it is difficult to find undervalued companies. The risk of changing such an investment to a lower quality one is high, so it is not worth taking the risk. Owners of temporarily overvalued but high-quality investments should be prepared for rapid price declines. According to Fisher's experience, most sellers of these shares do not return to their owners later, even if it would be reasonable to do so.
The fourth group is companies that are mediocre or poor in quality, but are either cheap or attractive in price. They may be suitable for speculators, but they are not sensible investments. The last group are stocks with high valuation levels compared to their quality and which the general public considers attractive investments. These stocks destroy the money and enthusiasm of many investors to invest. The investor has to ask himself whether the market's view is based on the correct valuation level, which is determined by the economic facts of the business?
Many investors base their view of a good time to buy on changes in the market prices of stocks. They can focus on analyzing historical price behavior, estimating the current price through historical highs and lows. They create an idea of a reasonable price for themselves and end up with a nice-looking even sum. This price is illogical and dangerous.
This method is dangerous because it causes the investor to focus on things that are not important and forget about the important things. Staring at prices often causes the investor to reject stocks that would give the best returns. Investors forget that the current price is only the collective view of the price produced by a large group of investors, i.e. buyers and sellers. A stock is either correctly or incorrectly valued, and the investor must understand the true value regardless of the crowd. The value of a business changes when changes occur in it. These can be the result of new management, products, or other things that affect the business.
Some investors also focus on comparing the behavior of a company’s share price to the historical price changes of the entire market and form their purchase price based on this. This thinking also causes the investor to focus on the wrong things. It causes the investor to create an illusion in his subconscious that all stocks rise or fall by the same amount. Following historical price changes in the market and comparing them to individual stocks also makes the investor think that he knows more facts. The increase in the amount of work makes the investor believe that his investments are significant, which leads to wrong conclusions.
One of the unnecessary mistakes of the investor, which Fisher mentions, is fighting over cents. Small changes in purchase prices do not affect returns much in the long run. If the quality of the company's business is in order, the investor may miss out on significant sums of money while fighting over a few cents. This is especially true for small investors who buy such small amounts of shares that they do not have to fight over cents.
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