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How are Stocks Valued? 

Professional investors value stocks through either fundamental analysis or technical analysis or a combination of the two.

 

At an overview, fundamental analysis values a stock's price by examining the factors that could influence it in the future. Technical analysis uses historical data to try and predict the future movement in share prices. Fundamental analysts believe the market is more logical than psychological. Technical analysts think vice versa. 

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Fundamental Analysis

Fundamental analysis is used to calculate a stocks intrinsic value, aka it's true value. If an investor calculates a stock's intrinsic value at £70, and it actually trades at £60 on the stock market, it makes the stock more attractive to buy. This is because the investor may believe the stock is undervalued. This is because they would expect the stock's price to move closer to its intrinsic value in the future. 

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The following factors are used to determine a stock's intrinsic value: 

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1. Expected future growth rate of the stock

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This is one of the main reasons why Tesla's share price has sky rocketed since its IPO. The electric vehicle market is expected to grow considerably in the future as we see the transition from fossil fuel powered cars to electric. With Tesla seen as a dominant force in the production of electric vehicles, it has led to its share price rising by over 20,000%. 

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2. Expected Dividend Payout

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A dividend is paid to shareholders when a company decides to share a proportion of the profits they have made. Any amount not distributed is taken to be re-invested in the business (aka retained earnings). If a company is expected to pay dividends out, it makes the shares more attractive to own, thus raising their price. 

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3. Degree of Risk

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A rational investor should be willing to pay a higher price for a share the less risky it is. 

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4. Level of market interest rates

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Opportunity cost of holding shares is greater when interest rates rise. This is due to the fact that the return on other assets such as bonds will rise, which might in turn reduce demand for stocks in general.  

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The calculation of a stock's intrinsic value is only an estimate though so 

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Technical Analysis

Technical analysis uses the past history of stock prices to predict the future. Essentially it is trying to understand how a crowd of investors is likely to act in the future. By having this information it will supposedly allow investors to beat the market by buying in before the crowd. 

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As mentioned earlier, technical analysis is much more psychological than it is rational. It hopes to benefit off of the crowd psychology. This is because if investors see a share's price rising they may want to jump on the bandwagon so they can profit off of its rise and not miss out. Any price will do as long as investors believe that others will be willing to pay more. 

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Dotcom Bubble - Irrational Market

The rise of the internet in the 1990s, saw an incredible amount of optimism placed on the potential of internet stocks, as it was clear the internet was going to fundamentally change the manner in which business was done. Valuations of companies were often based on earnings and profits that would not occur for several years. A huge amount of capital poured into the stock market as investors expected virtually any company who had a presence on the internet to blow up. The Nasdaq, which is one of the most widely followed indices in America, rose five fold between 1995 and 2000. This period of rising stock prices is known as the Dotcom bubble. 

 

Many companies listed on the stock market during this period, only to fail a short time later with their completely failed business models. Pets.com was a classic example of this, who managed to raise $82.5 million in its February 2000 IPO, due to its ability to run an extremely successful marketing campaign, with even funding an ad during the super bowl. The company experienced massive challenges with high competition from pet stores and difficulty shipping large products. In no more than 10 months the company had gone bankrupt. This was a similar story for many other companies such as Boo.com, Webvan and etoys.com. 

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The Dotcom bubble is a perfect example of when the market was a whole lot more psychological than it was rational. However, the bubble burst in 2000 as a result of all of these extremely weak technology companies collapsed. Trillions of dollars of investment capital were lost. 

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