Aimlock on The Dream Stock 🎯
In this lesson, we sketch out the ideal stock we’re hunting for. It’s simple enough, and it’ll be our northstar as we progress through the these stock-picking lessons. First however, you’ll learn the cornerstone method for valuing stocks with multiples, and three value investing tactics that are very successful. One concerns bankrupt business stocks, another dividends, and the final has to do with exceptional businesses whose stocks are compound machines. Sounds juicy! Let’s get started!
Multiples Are Dead Simple.
Multiples help you value companies. When you divide one business metric by another, you’ve got a multiple, otherwise known as a ratio. The flagship multiple is the P/E. That’s price over earnings, and its supposed to indicate value for money.
|Price/Earnings||Corresponding Yearly Return|
You can think of the P/E multiple as however many dollars of stock price you need to buy to make $1.
The P/E is utterly useless as an investing metric because companies can so easily manipulate their net income, which you don’t get by the way. It’s also a lazy shortcut which doesn’t tell you the story of a stock. Feel free to engineer multiples you think would be useful when comparing one company to another, other frequently used multiples being the price/sales, price/free cash flow, and debt/equity. You’ll learn about those in the next lesson.
The Twist 🌀
If a businesses is out there on the stock market for very low PE ratio, it’s probably down at that low PE for a reason. Investors feel negatively towards the company. They feel pessimistic or uncertain about how much money the business could make in the future for them. As a result, the stock price and multiple has found an equilibrium where investors will agree to become owners because the return just about compensates them for the risks they see. That explains stock prices in a nutshell.
So, What About My Favourite Hot Stocks? 🔥
I don’t know what’s hot to you but everything the hosts on CNBC talk about all day is exactly not what we should be thinking about. Emerging industries and stocks that are in fashion end up too expensive to offer a decent return. It’s very difficult to outperform an index as a value investor by investing in these companies because they’re so noisy and heavily followed by competing investors. An investment would be more of a momentum move than a value investing move, because your betting on greater fools theory.
That’s not to say these businesses are suddenly shoddy businesses because they’re expensive. They’re awesome businesses, the best in the world! But fame is our problem. Everyone already knows about these stocks so there’s very little edge left for us in investing. The multiples are too high. I think I showed you that with Amazon.
Value Investing Fishing Holes 🎣
Aside from multiples, there are other signals in stocks and businesses that can make them interesting prospects. All of these are sound.
The Perfect Franchise Stock 😍