From what does a share derive its real value?

We have seen that Warren Buffett, in achieving his success, relies on two skills, Market Tuning and Stock Selection. In this section of the hook, you will he introduced to these two skills which are the basic “weapons” of a fundamentalist investor. The Next articles will examine the question of why a market moves up and down and whether it is possible to determine when is the correct time to buy or sell shares.

The rest of this section is devoted to an introduction to the fundamentalist approach to share investment, This approach is based on the belief that all shares have an ‘intrinsic’ or real value, At any one time, the market price of a share can be very different from its intrinsic value. The market price may be higher or lower but eventually the price will return to the share’s intrinsic value. This approach to investment depends on knowing what the intrinsic value of a share is and buying the share only if its market price is considerably below its intrinsic value. The share is then held until the market price rises to well above the intrinsic value at which tune the share can be sold with a capital gain. The fundamental approach may he represented by the following figure indicating the idealized price movement pattern.

Ideally, the investor would buy the share at point Under Priced and sell at point Over Priced. To use this strategy successfully, the investor must be able to do two things well:

(a) He must be able to tell what the intrinsic value of a share is. This means he must have the ability to evaluate a share for its true worth.

(b) He must be able to tell at what point the market price has moved so far away from its intrinsic value that a price reversal is imminent. That is, he should be able to tell when a falling share will start moving up again and when a rising share will start to decline. That is, he must be able to time his purchases and sales.

This is of course the ideal situation, there is probably no one in this world who can do these two things consistently well. As amateurs, we must be willing to accept our own shortcomings. We are likely to make mistakes regarding the intrinsic value of a share; the ugly frogs we pick will not always turn into princes. Neither will we even come close in predicting the turning points in a share’s price movement. But taking all our purchases and sales into consideration, we should come out ahead.

We shall be devoting a considerable amount of space in the second half of this book to helping you to develop these two skills. We shall make a start by examining what is the factor which determines the value of a share. Considerable amount of evidence will be shown to convince you that the long term value of a share is dependent on the amount of dividend it provides. In Next article we shall attempt to destroy the commonest myth of the local market that bonus issues increase the value of shares.