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Source: www.fanews.co.za
One of the most important things to avoid in investing is permanent capital loss, because it is twice as hard to make up for that loss. For example, if you buy a share at R100 and its price drops by 50% to R50, to make up for that loss your share has to double in price - i.e. make a gain of 100% - just to break even. Of course, the greater the fall in price, the greater the return must be just to reach an overall return of zero.

Make sure to pay a fair price

There are a number of factors that can cause a permanent loss to occur that are beyond an investor's control, such as geopolitical and economic events that affect markets as a whole.

One factor you can control as an investor is the price at which you buy a share. Share prices can become highly inflated for many reasons.

Ultimately, it's a question of supply and demand. The more demand there is for a company's shares, the higher the price it is likely to trade at. Demand can be driven by market hype that has little to do with the inherent quality of the company whose shares you're buying. This results in a price distortion. Of course, demand can also be driven by legitimate reasons, such as the company having found a new market for its products, or developed a new offering that will add substantially to its revenue.

On the other hand, over-supply can drive a company's share price down. Again, many short-term events can have this effect. A company scandal or an unexpected loss in operating profit can see investors running for the hills, selling their shares at ever lower prices just to avoid further losses.

Sometimes this is the right thing to do and shares are cheap for legitimate reasons - perhaps the company is being mismanaged and losing money, or demand for its product has died off because a new type of product has come onto the market.

Often, however, the reason a share has lost value is simply market noise, caused by investors' fear and greed. In this instance, you might be looking at a buying opportunity.

Determining fair value

Discerning the difference between these two scenarios takes research and skill.

The first step is to ascertain the actual intrinsic value of a share. If the company were to be sold, what would an astute investor pay for it, and how would this translate into the price of its shares?

Factors to consider include:

  • The company's track record of financial performance - does it have a history of making good profits?
  • Is there a strong market for the company's products and services, and how sustainable is this market?
  • What is going on in the competitive environment? Is it easy for other companies to enter the market with their own offerings, or does the company you’re interested in have a particular competitive advantage that will make it difficult for others to take away market share?

These are just a few of the many questions you need to ask when evaluating the price of a share. Calculating intrinsic value is no easy feat for the average investor - it is even complicated for professionals, and sometimes they get it wrong. To account for this possibility, it makes sense to try to buy a share at below its theoretical intrinsic value - in this way you give yourself a margin of safety if your calculations are a little off.
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