Can you compare the price of a Mercedes S-Class and that of a Maruti-800?
Of course, one costs Rs 60 lac while the other costs less than Rs 3 lac. And you can compare Rs 60 lac with Rs 3 lac.
But then, is that the right comparison? I mean, isn’t this the same as comparing apples to oranges?
The two cars have different values in terms of luxury, safety, quality, and brand value. So comparing them just on their prices won’t be the right idea. You need to see the difference in their values.
After all…
The same goes for stocks. A Rs 50 stock might be considered cheaper than a Rs 500 stock. But that’s an incorrect way of looking at it, just like comparing the price of a Mercedes with a Maruti-800.
As we learnt in the third lesson, a stock is not a piece of paper but a share in a business. So it is important to compare a stock’s price with the company’s business value (and not with anything else, ever!) to ascertain whether it is cheap or expensive as compared to another stock, and also in isolation.
The Rs 50 stock might be backed by a business whose value is Rs 25 – thus a price-to-value of 2 times (50 divided by 25). On the other hand, the Rs 500 stock might be backed by a business whose value is Rs 1,000 – thus a price-to-value of just 0.5 times (500 divided by 1,000).
What this means is that the first stock is priced at 2 times the business value, while the second stock is priced at thus 0.5 times (or 50%) the business value.
Now, which is cheaper? The Rs 50 stock, or the Rs 500 stock? Based on this short analysis, the Rs 500 stock definitely looks cheaper. Isn’t it?
Anyways, the idea of this discussion is to bring to light the key investing concept of ‘intrinsic value’. In simpler terms, you can also call it the ‘core business value’.
So, why you should calculate intrinsic value?
The price you are paying is the ultimate determinant for the rate of return that you’ll be earning from a stock. The higher the price you pay for it, the lower will be your return. As simple as that!
And that is why you need to know how much a stock is really worth. Once you know its intrinsic value, you can identify if the stock is trading cheap or expensive. A very high stock price as compared to the business’ intrinsic value means that the stock is expensive (like our first stock above). And a low price as compared to the intrinsic value means that the stock is cheap (like the second stock as discussed above).
These are general rules of thumb. We will understand the specifics of how much price to intrinsic value makes a stock cheap or expensive in the next two lessons. And we will also study the different ways you can calculate the intrinsic value of a stock.
But for starters, remember that intrinsic value is an estimate rather than a precise figure. And it is an estimate that must be changed with changes in the variables that are used to calculate it (don’t worry, we will study all that in the next two lessons!)
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