When you buy a stock, you are purchasing a piece of a business. You are not buying some ticker symbol that fluctuates up and down every minute of the day. That is the first difference between how a value investor and a speculator looks at stocks. Those who speculate believe someone else is willing to pay a higher price than what they've paid for a stock and could careless about how the business itself functions.
If a stock represents partial ownership in a business, how do you value the business? Ideally we want to pay less for what the business is worth. The key is to think about how much the business can produce.
Let's say you want to purchase an investment property. You see that there is a three bedroom and two bath 2,500 Sq Ft. house selling for $500,000 in Los Angeles, CA. Suppose the average rent in the area is $3,500 per month or $42,000 a year. You also put a down payment of 20% or $100,000. Let's also factor in your costs including property tax ($5,000), repairs and maintenance fees ($800), home insurance ($1,200), and mortgage payment ($23,000), which total $27,000 for the first year. Assuming no vacancy in your first year, we estimate a cash profit of $12,000 or $42,000 (rental income) less $30,000 of costs. This means that on your $100,000 down payment investment
you earn about a 12% return in the first year.
The key is to think about how much the business can produce.
We look at businesses the same way; we want to see how much the return is on our investment. With stocks, we can look at it as if we are buying the entire business. How do we know how much a business cost? You can calculate how much the stock market is valuing a company by taking the number of outstanding shares and multiplying it by price of each share. That will give you the market capitalization or market cap. Meaning if you wanted to buy all the shares
of that company, it would cost you the market cap. You can find the outstanding shares count on the first page of the company's latest 10-Q or 10-K filing. The 10-Q or 10-K can be found on the SEC.gov website or at the company's investor relations page.
Now if you purchased 100 shares of a company that has a market cap of $1,000,000 and the cash profit of that company was $100,000 that year then you would've effectively earned a 10% return. The same would be if you purchase 20,000 shares at a market cap valuation of $1M.
Labels: Value Investing