Learn Stock Market Investing

Last time in “How you can make money through stock market investing – Part 1” we talked about the first way wherein you can make money through stock market investing and that is through dividends. We talk about the second way to make money in stock market investing in this post.

2.) Capital Appreciation

Capital appreciation or Capital gains are simply profits made from the increase of the market price of a stock.

To understand this let me give you an illustration. Suppose you went into business and put up a lemonade stand. Your initial capital is P 500.00. You bought some lemons, some ice, some cold water, cups etc. At the end of the day deducting all expenses, you made a net profit of P 500.00. Now all in all you have P 1,000 including your initial capital. Suppose you plow it back to your lemonade business and the next day you made P1,000.00. Now you have P 2,000. So from an initial capital of P 500.00 your capital has now grown to P 2,000.00. The growth in your capital is made possible because your business has grown and expanded.

Capital appreciation in stocks has basically the same concept. Since stocks represents businesses, as time goes by a good business is sure to grow and expand. If you own stocks in a business you are one of the owners of the business so therefore you benefit from the growth of the business. In other words your capital (The amount of money you used to buy stocks) will appreciate. If you later on plan to sell your stocks of course you will not sell it for the same price that you brought it. The business has already grown and surely you would not sell for the price that you bought it for. This just makes business sense. The difference in your selling price and your buying price is your profit.

Aside from the natural business growth that the company will be experiencing as time goes on, another factor that contributes to capital appreciation is the over valuation of the stock market of certain stocks. Sometimes the market acts foolishly and starts to value stocks based on flimsy projections and not so much on the actual business fundamentals but on the anticipated price that a certain stock might reach oftentimes, rumors and the general “bulish” outlook of the market also contribute to this “over valuation” of stocks. (To further understand this read my latest post entitled “How the market really works”)

To understand this, let me cite an example. Let’s say I hold (Philippine long distance telephone company) PLDT stocks today worth P 2,500 per share. Then you come along, you heard a rumor that PLDT will be bought out by AT & T and that the share price will reach P 3,000 per share within a month. You want to buy it from me at P2,800. Since your offer looks nice and I haven’t heard the rumor I sell it to you at P2,800. A month has passed and you are holding the PLDT stock which you bought at P2,800. You realized that the rumor was not true at all. Worst is that two bad news breaks out. First is that PLDT has not reached its quarterly sales target and second is that a rival telecom company has started to gain more subscribers than PLDT. You start to worry, the market prices PLDT at only P 2,750. Sensing that the price might slide down further, you decided to sell at a loss at P 2,750. Another person by the name of Juan Delacruz does a company evaluation and hears a rumor that PLDT will be merging with MERALCO (Manila Eletric Company) and that the two companies will be doing an internet via electricity deal.

Juan Delacruz estimates that the price of PLDT will reach P 3,500 in a month’s time. So he buys your PLDT shares at P 2,750.00. True enough after a months time the rumor came true. PLDT merged with MERALCO and the market values the stock at P 4,000 per share! Happy days are here again. When other stock market players hear of Juan Dela Cruz‘and other market player’s huge gains in PLDT, they jump into the band wagon pushing the price further to P 5,000 per share until the price reached P10,000.00 per share! And everyone lived happily ever after! (Unfortunately the ending is not as happy as that because the bubble always pops and the market later on realized that it has overvalued stocks so the price goes down later the sad story of course is the subject of another post)

Now this may sound very simplistic but this is what moves the price up. Stock market players oftentimes over value the price of stocks. Some of them do this intelligently, that is they base their decision on sound business valuation of certain stocks however some if not most stock market players do this without any regards for the business that the stock represents. They just do it out of too much greed. They just buy, buy, buy without regards to what the stock is really worth from a business perspective.

A perfect real life example of an over valuation of a certain stock done by the market is the BW (Best World Gaming and Entertainment Corporation) scandal of 1999 which almost crashed the Philippine stock market. (And caused a lot of people to loose their shirts) Fueled by speculation and rumors the stock traded for more than 30 times book value and jumped from a mere Php0.80 (US$0.0166) to Php145.00 (US$3.01) in just a year’s time! (October 1998 to October 1999) An astounding 18,025% increase! (This despite the fact that a quick look at the company’s fundamentals reveals that it is not a good investment if you use good business sense)

This foolish and greedy “over evaluation” of the stock market of certain stocks from time to time further adds to the gains that can be made from the capital appreciation of stocks.

Come back for “How you can make money through stock market investing  - Part 3“

Hi ! my name is  Zigfred Diaz, Thanks for visiting my blog where you can learn stock market investing the Warren Buffett way and using other value investing methods ! Never miss a post from this blog. Subscribe to my full feeds for free. Click here to subscribe to D’Intelligent Investor by Email

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