Anandi, you have asked a fundamental question and my views will be like one of the blind men stating that an elephant is like a snake. In other words, it will be a partial truth and there maybe many parts of the elephant that I am missing.
The share price represents the money value at which an owner of a share is willing to give it to another person.
The true value of a share, if it can be determined at all, is what is universally acknowledged to be a ‘fair’ price for a share.
Let me start with a story which I use to start such a discussion. Suppose say that you find yourself in a situation where you are so dehydrated that if you don’t get some water to drink in the next few minutes you will die of thirst. At the time let’s say you pray to Laxmi and offer say Rs 1 lac (Rs. 100,000) for a bottle of water. Hearing your prayers Laxmi propitiates herself as an itinerant saleswoman who offers you a litre of water for Rs. 1 lac. You pay cash and after drinking the water you are now back to full form. At the time the true value of a litre of water to you was Rs. 1 lac.
The water bottle seller is like the seller of shares in that she is trying to get the best price for her goods. Your willingness to pay Rs. 1 lac for the bottle of water is the price a share buyer pays for the share. So the share price will go up when there are more buyers bidding up the price of a scarce share and vice versa.
Suppose say you reach home and narrate this incident to your family. Ashish, your CA brother immediately pulls out his calculator and computes the costs the water producer would have incurred in supplying the bottle of water to you. He informs you that at the most you should have paid maximum Rs. 1000 for the bottle of water. In other words he tells you that you have been ripped of by Rs. 99,000.
Just as Ashish computed the costs of supplying a water bottle to you, stock market analysts who focus on fundamentals use the firm’s balance sheets, P&L accounts and quarterly public statements to estimate the ‘true value’ of a share. However, this method also has its drawbacks in that it is like driving a car by looking at the rear view mirror. It assumes that the past performance of a business is an accurate predictor of the firm’s future prospects. Of course, there is the added risk of trusting the financial statements of any business. The list of auditing scandals will have raised sufficient questions in your mind on the reliability of financial statements. To quote my teacher, ‘It’s not the figures lying, but the liars figuring’.
Let me end with a story. Two learned friends were arguing in the presence of a third, when the third suggested that we go to Confucius to resolve the issue. The first man went in and Confucius told him that he was right. The second man who narrated his version also got the same Confucian reply. The third friend now went in and told Confucius how can it be that both are right and Confucius told him ‘You are also right’.
In other words there is no true value of a company, it is based on individual and often irrational perceptions of value.
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Hey Girish that is certainly helpful. However my next question would then be how does one cut through the fog to get a clearer picture? Maybe you could explain significance of P/E ratio and any other relevant parameter?
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