Businessman Investor

Touching base with the rational business psyche of stock market investors

Sunday, November 2, 2014

The Stock Price Tag being Dictated by Your Required Rate of Return

Stock Price Tag. The price a rational investor pays for a
stock would have an implied rate of return. Because the 
price one pays dictates his rate of return. Or put in another 
way, one's required rate of return dictates the fair price to pay. 
A price tag is not appraised just for the sake of it.
When someone appraises a stock and assigns a fair price tag for it, what exactly does that imply? To most of us, it's fairly intuitive: it just means that it should be bought at or below that price. Simple enough, isn't it? But let's say you are indeed able to buy it at that price, what's next? What should be the expectation?

My criticism of simply appraising a stock for the sake of it is that it loses track of why one is appraising it in the first place. My personal view is: a fair price should be appraised based on an expected rate of return. I cannot further stress the importance of this point.

A rational investor and capitalist buys a stock because first and foremost, he expects a certain rate of return from it. So yes, that is where it should all begin. A rational investor, even before buying into a stock position, should have a set required rate of return. This is the very basis of stock appraisal. Because the price one pays dictates his rate of return. Or put in another way, one's required rate of return dictates the fair price to pay.

When someone declares, "XYZ company's fair price is $70/share.", I would ask back, "so if you're able to buy it at that price, then what's your expected rate of return?", "How much money will you be making from it in the long-run?"

For me, instead of asking: "what is the fair price for stock XYZ?" I think it makes more sense and more analytical to ask, "What is the fair price to buy XYZ to achieve 15% return?", or "At the price XYZ is doing, what approximate return would it be yielding?" Asking the first question is a dead-end analysis. It stops there. The latter two questions tie-in the return aspect of appraisal.

Of course, this has a bias on having a long-term view on the stock. Because stock appraisals would naturally and most likely be based on some discounted cash flow model, which by their very nature are entangled on some forecasted cash flow which run by years, or even a decade or more. And since they deal with cash flow forecasts, these are intrinsically entangled with the fundamental nature of the underlying business. Which goes back to the point that if one buys on the basis of a model that has a long-term forecast, then one should also be logically (in its strictest sense) be long on the stock, to achieve that expected return on which that appraisal has been based on.

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