Posted by Robert on July 19, 2010
Investing in the stock market is a roller coaster ride. People should know what to expect before getting on. Once we are on, it can take us from dizzying highs to stomach-turning lows. The difference with the stock market is that we can choose to get off at any point. People are more frightened by a quick drop than by a steep climb, so it’s not uncommon to see people getting out at the bottom. How can that be a form of investing and not outright gambling?
Legendary investor Benjamin Graham, the mentor of Warren Buffet, explained that price does not always equal value. That’s sometimes difficult to see because we are not used to negotiating prices. In the grocery store, the price on the tag is the price we pay. The same applies to almost all shopping, with the most common exceptions of cars and houses. But price does not always equal value. Think, for example, of sales. The price is lowered, but has the value changed? What is the true value: the sale price, or the original price? In the stock market, the changes in price are more common and more extreme, further obscuring value.
Ben Graham offered an analogy to investing in the market. Imagine you work in a business partnership with a manic depressive called Mr. Market. Every day he comes in to work and, depending on how he’s feeling, names a price at which he’s willing to buy your portion of the business or sell you his portion of the business. Some days he’s manic, and willing to pay a high price to buy your shares. Other days, he’s depressive and willing to sell you his shares at a low price. What would you do? I would try to determine, within a reasonable range, a fair value for the business, so that I could buy from him when he’s depressive and sell to him when he’s manic.
That is a very fair comparison to what goes on in the stock market. Just because the price varies daily and hourly, the value of the company doesn’t necessarily. If you read financial media (which I don’t advise), you’ll see that the market price of a company supposedly rises and falls due to global economic outlook, local investor outlook and sometimes because of reasons that aren’t even related. It comes down to investor sentiment, and people will pay higher prices when they’re optimistic, and offer only lower prices when they’re pessimistic.
Determining value doesn’t require an advanced education. Investing means buying cash flow, so the value of a company depends on the profits they are expected to earn and the dependability of future earnings. We can do this by looking at past earnings to find how profitable the company has been, and how consistent the earnings have been. Unless there’s a real event that will cause lower (or higher) profitability in future, it’s normal to pay around 15 times earnings. This is the P/E (price/earnings) ratio. Around 15 is seen as normal, over 20 is seen as high and under 10 is seen as low.
When I walk into a grocery store, and I see soup on sale, I don’t think: “It’s going to zero, time to sell all my canned soup!” Buying low means buying on sale. Companies whose stock price is cheap relative to earnings are more likely to offer good value for money. Later, there are two reasons I may sell. If someone is willing to pay me more than my shares are worth, there’s an opportunity to profit. On the other hand, if there’s a real reason to think the company will be less profitable in future and the value has broken down, selling is usually the best option.
Not everyone has the confidence and patience to invest in the stock market. Wild fluctuations are normal and distracting. Finding the true value is not a science and is prone to error. However, if I can determine the likely value of a company (within a reasonable range) and buy it cheaper, I can have confidence that I’ll profit over time. How do you stay calm during days, weeks or months when stock markets fall? How do you decide when to buy and when to sell?