“The Value Investing Way” Part II
Photo credit: Mackenzi Marie
How do you know if you’re buying a stock at too high of a price? This is a question I had no idea how to answer previous to becoming acquainted with the value investing approach as I mentioned in my last post. I did not understand how a stock trading at $100 a share for company A could be cheaper than a stock trading at $50 per share for company B. You may have just read that last sentence and it makes absolutely no sense to you as well. If that’s the case, keep reading and hopefully I can walk you through the way you should look at the price of a stock and it’ll all come together.
So how can a stock trading at $100 per share for company A be cheaper than a stock trading for $50 per share at company B? The answer is actually very simple when you break it down into smaller numbers. To start with, you want to look at the company’s balance sheet, which can be easily accessed on the company’s website under investor’s relations or on a research site such as yahoo finance. On the balance sheet you can find out how many shares the company has issued, or the number of “outstanding shares” as it will read. This number is important because it will tell you what your percentage of ownership in the company will be when you buy your share or shares. Again, to keep it simple, let’s assume that company A trading at $100 per share only has 10 shares issued. If you buy one of those 10 shares, then that means you are now 10% owner of the company. Next, let’s assume that company B trading at $50 per share has 20 shares issued. If you buy one share, that means you own 5% of the company. By looking at the number of shares outstanding, you can see what percentage of ownership you’re getting, which translates into how much of the company’s earnings you’re entitled to.
At the end of the day, one of the most important drivers of returns will be the underlying earnings of the company. You want to buy earnings! Going back to the example above, you now need to know how much in earnings these companies generated to determine which company is a better investment. To find out the earnings, you now need to locate the income statement where you can find the “bottom line” as it’s called, or the final net income of the company. Let’s assume company A had a total net income of $200 and company B had a total net income of $50. Once total net income is determined, you want to divide the total net income by the total shares outstanding to come up with a very useful metric called “Earnings Per Share”, which is typically abbreviated as “EPS.” The “Earnings Per Share” for company A is $20, and the “Earnings Per Share” for company “B” is $2.50. For company A, you’re paying $100 to get a company that is generating $20 in earnings. For company B, you’re paying $50 to get a company that is generating $2.50 in earnings. All things being equal, which company would you rather own if you were thinking about becoming part owner in a business? Hopefully, you answered company A. Company A is providing an earnings yield of 20%, ($20 earnings/$100 price per share), and company B is only providing an earnings yield of 5%, ($2.50 earnings/$50 price per share.) If earnings are one of the main driving forces of stock investment returns, you want to buy as much earnings as possible.
The good news for a new investor is that most company annual statements or financial websites break down the earnings per share for you, so all you have to do is divide the EPS by the price per share to get the earnings yield. Earnings yield is certainly not the sole determining criteria when considering investing in a company, but it is a great metric to get an idea of whether a company is cheap or expensive. In our example, that simple metric shows how company A would be cheaper in the sense that an investor is getting more earnings for each dollar invested compared to company B. Hopefully now you know how a $100 stock can be cheaper than a $50 stock and you can look beyond the price per share to the underlying earnings of the company and what percentage of those earnings you’re buying.
The value investing approach brings many of these metrics like the “Earnings Per Share” that we just discussed that are helpful in helping an investor know when to buy or not to buy a company. As a general rule, if a company only has an earnings yield of 1% and a very modest growth rate, you probably don’t want to buy that company. However, if you can find a stock like company A where you’re getting 20% earnings yields, that would be an exception yield and certainly worth looking into. The price you pay relative to earnings is very important, don’t forget that. There are many great companies out there that I do not currently own because the price of the stock has been driven up too high relative to their earnings and I’m not willing to pay up for that company, but I keep them on my watch list waiting for that day when investors decide to drop their shares, even though the underlying earnings of the company are not in danger. People are emotional, but the “Value Investing Way” is very rational, and that’s what I like about it.