Yesterday, I met some ex-colleagues who are also friends. Since I moved onto to do something very different – investing in stocks, there is some curiosity about what is it that I do, how am I faring and if the move has been worthwhile. You know, all the proxy questions to “how much do you actually make?”.

Now- everybody, and I mean EVERYBODY, knows that when you invest in stocks, you make money buying low and selling high. But what happens if the prices were to go down instead of up?

That’s where the concept of intrinsic value comes. In all transactions of life, including investing, there are two parts. One is the Price that you are paying and the other is Value that you are getting in return. That is, Price is what you pay and value is what you get. We, as investors love deals where Value >> Price.

So I laid out a real life example. Imagine there is a company that has Rs 110 in cash and no liabilities and you can buy it for Rs 50. In other words, price paid is Rs 50 and value got is Rs 110. In this case, Value > 2X Price. For every rupee you pay, that is like getting more than two back. Isn’t that a good deal?

And what happens if the price goes down to say Rs 30. Now, you could buy the same company for Rs 30 and yet you get access to the same Rs 110 of cash. Now, Value > 3X Price. In other words, isn’t that an even better deal than before? So is it a bad thing that prices go down but value remains the same? Of course, not.

Now say, there was a scenario where the price was Rs 150.  You’d pay Rs 150 but get back only Rs 110. This time, Value < Price. You tell me, is it a good deal or a bad deal? Of course it’s a bad deal and it would leave you poorer.

As you can see, all along I am anchoring my thesis on the intrinsic value of Rs 110 of cash in the company and not so much on the price.

But what if, after you buy, the price just keeps falling and falling and never comes back?

This happens to every body. Even to Warren Buffett. But let me draw your attention to something. Every investment in stocks can have only 4 outcomes – Big Win, Small Win, Big Loss, Small Loss. So we try to avoid Big Loss kind of scenarios while being open to accept any of the other 3 outcomes. This is the best that we can do.

In my next blog, I’ll share some thoughts on how to avoid Big Loss.

Thanks for reading!