Investment advice: How markets set prices on company shares

WITH global stock markets experiencing high levels of volatility, it is timely to build on the time value of money concept discussed in my last article and look at what makes up a public company's share price.

That volatility has been led by China stocks which, incredibly, gained over 140% in the 12 months to June this year and have since lost almost 60%.

As the name suggests, a share is a fractional interest in a company.

A share is worth the value of the business operated by the company, divided by the number of shares.

In simple terms, the business is worth the sum of its future cashflows in today's dollars.

You will recall that this 'present value' can be calculate by 'discounting' those future cashflows by a discount rate equivalent to the opportunity cost of the capital invested to establish and operate the business.

Arriving at the appropriate discount rate which properly reflects the opportunity cost of capital is a complex process, over which leading finance experts often disagree.

However, the concept is not difficult to understand: it is the rate of return expected from an investment of similar risk.

This is essentially made up of the return on so-called 'risk-free' securities (eg government bonds) plus a risk premium an investor requires given the risk of the business relative to overall market risk ('Beta' in finance speak).

The cost of debt capital also plays a role.

Unlike property or private businesses, the value of a public company is set and re-set hundreds of times a day as buyers and sellers trade shares.

This explains why current uncertainty concerning China's economy, the Syrian crisis and expected US interest rate rises, is causing a lot of volatility in global share markets.

However, not all investors look at risk the same way, nor apply detailed analysis before making decisions.

Therefore emotion and other idiosyncratic characteristics add to this volatility and can present opportunities for the disciplined investor.

* CAMPBELL KORFF is the principal of Yellow Brick Road Wealth Management, Northern Rivers.

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