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TL;DR: "In the short term, the market is a voting machine. But, in the long term, the
market is a weighing machine". -- Ben Graham[1]
Part 1: How the stock market works
Part 2: How does one evaluate Stocks
Let us use a simple example. If you assume Apple's next year EPS will be $48, the
expected interest rate for such a risky company at 15% and an expected annual growth
rate at 5%, you will get:
$48/(15%-5%) or $48/10% or $480 as the ideal stock price for the company. Where did I
get this magical 5% number?
Getting the growth inputs:
Now, we need to find the growth rate of the company and figure out what the company
will earn in the next year, the following year and so on. This is not an exact science and
no one has a perfect answer to this question. This is why we need stock markets.
Collectively, we all pool our intelligence to figure out the future growth of the company
and thereby its current price.
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To do this collective prediction, we constantly get new inputs and project that to future.
For instance, if the company management gets hotshot new engineers, then we predict
the future will be bright. What are the other news that investors typically use:
Periodic financial results of the company that gives us a view into the
company;s workings and its financial position
Periodic results of similar companies that helps us guess this company;s
results. Thus, when Apple sneezes everyone else catches a cold.
Changes in the sector. If a new report comes that people are more inclined to
using mobile phones, we predict growth of these companies will be high.
Changes in the broader market.
Changes in the international economy
Market Estimation:
In short, we try to use every possible information to guess the future growth of the
company, plug that into our formula and find out the stock price. For instance, if Apple
comes out a report saying people are buying less of iPads, we might ding Samsung too as
we believe their Galaxy Tabs will sell less too.
Estimating growth rate is an art rather than a science, and is collectively done by
millions of humans in a place called the stock market. Since, we need to constantly
adjust the growth rate based on new information, stock prices constantly fluctuate.
Main advantages of a stock market:
1. Starting/building a business: The market lets companies get money from a large
number of people. That means there are more options to get money to build a business.
2. Spreading risk: It lets you spread the risk of a business into a large number of
people. Since, each person is investing only a small portion of their income in the stock
of a particular company, the risk of a single company collapsing doesn't significantly
affect investors.
3. Collective estimation of value.
Summary: Modern corporations require a lot of capital, which is beyond the reaches of
a few individuals. Markets help companies raise money from a large number of people
and together these investors value their company. The theory is that when a large
number of people do their independent valuation, the company's price comes more
closer to its ideal worth.
"In the short term, the market is a voting machine. But, in the long term, the market is a
weighing machine". -- Buffett