Sunday, August 19, 2012

Investing Tutorial - Part 2 (Stock Valuation)

In the last post, we were discussing the relationship of my analogy to companies, or their stocks as investments. If you haven't read the previous post, this post won't make much sense, so I encourage you to go back and read it. That being said, let's move forward.

What makes a great company great? Think about a company like Nike. It has great (cool and stylish) products, a large and loyal customer base, and great brand recognition. The same goes for Apple. And those  aforementioned qualities are the reasons these companies' stock prices have soared over the last two decades. Great products and a loyal customer base usually translate into consistently high revenues, which also, for these companies, equals higher earnings.

Investment analysts determine whether or not a company is "expensive" by determining what multiple of earnings or some other metric of profitability/worth that the stock is trading at. For instance, if a company has $2.00 per share of earnings and its stock price is $20, its "price to earnings ratio" or P/E multiple, is 10. Similarly, if a company has the same $2.00 per share worth of earnings, but has a stock price of $100, that stock's P/E multiple is 50. An average P/E is about 20 -25 and the P/E ratio will vary depending on the industry that the company is in. Fast growing technology companies usually have nosebleed P/E ratios and more boring companies like car companies or waste removal companies trade at lower multiples. This is because investors are willing to pay more for companies that are growing really fast.

Facebook is an example of a fast growing company that trades at a high multiple, and is a cautionary tale about investing in high multiple stocks. Unless you live under a rock, you've probably heard that Facebook recently had an IPO (initial public offering). And when it came public, its P/E multiple was a whopping 155!! (This was calculated by dividing its initial price at the time of the IPO of $45 by its earnings of $.29.) Since then, the stock has lost approximately 60% of its value and it still trades at a multiple of 65! And remember that I said a normal P/E is in the 20 - 25 range.

Here we return to Graham's admonition regarding thorough research and ensuring to the best of one's ability that an investment will not lose money. Although it is impossible to determine whether an investment will lose money (unless of course you're a fortune teller, in which case, please call me), there are ways to mitigate risk certainly. It has been empirically proven that stocks with high multiples get treated more harshly by Wall Street (in terms of high volume selling that drives down the price) when they fail to meet expectations than below average multiple stocks. This is because high expectations are already taken into account by the price. So if high multiple stocks seem to be risky, then it follows that low multiple stocks should be less risky.

For the most part, that assertion is true and a whole body of investing has evolved around that very premise. The type of investing that focuses on stocks with low multiples of price to earnings, or price to free cash flow, or price to book value is called value investing.

Value investing, in keeping with Benjamin Graham's assertion about protecting principal, proposes that the best way to do so is to buy stocks with what's called a margin of safety. In the next post, I'll discuss this concept in greater depth and talk about how to calculate it.


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