A big part of learning how to evaluate a stock is determining whether the stock is trading at a good price or not. You could buy a stock with the best business in the world but still get a terrible return on your investment if you pay too much.
This is something that unfortunately gets forgotten by many investors who buy individual stocks.
The mindset needs to shift from “buying now and selling to someone else later” to “buying a business at a reasonable price and holding for the long term”. The former requires impeccable timing while the latter provides much more room for error.
When buying stocks, it’s imperative to utilize a system that predicates its success on the general principles behind it rather than the investor’s skills. After all, Warren Buffett was quoted as saying “Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Rationality is essential.”.
To figure out what makes up a great price, and how we can use that to evaluate a stock, it’s important to first consider what sets prices in the marketplace as a whole, and then clarify it inside of the marketplace known as Wall Street’s stock market.
The Economics of Price (101)
What makes the price of something?
Last I checked, there’s no book somewhere that definitely sets the price for any one item. There’s no Kelly Blue Book for a loaf of bread, or a dozen eggs, or a gallon of milk.
Even the Kelly Blue Book for a car can be wildly inaccurate and depend on many other factors like the condition of the car and the used car market.
The price of something depends on supply vs. demand. It’s the sweet spot where two people (or a person and a business) can agree to swap goods or services.
Demand plays a huge role. What happens when a store goes out of business? and why?
Well if a store goes out of business it means they didn’t have enough customers. Low demand. They usually do a going out-of-business sale, lowering the price to temporarily increase demand and get rid of their supply (inventory).
When something is in high demand (like water bottles at an outdoor concert venue), the price can be much higher than normal and still sell. Or when supply gets lowered (like the oil shortage in the 1970s), the price will also skyrocket. It’s simply supply and demand.
You can relate this to many different things. High luxury clothing gets priced much higher– and those companies stay in business because of high demand.
When a clothing brand doesn’t have high demand, it must rely on competing on price or convenience– it must be priced lower or comparable to competitors, or that company goes out of business.
The same concept is prevalent in the stock market. The price of any stock changes based on how many people want to own it at any given day.
Just like with goods, you can choose to buy a stock when demand is high or low, supply is high or low, and the price is high or low. A stock with high demand and high price will have a high valuation. Examples of this right now are Tesla, Chipotle, and Netflix.
You can also react to prices and pick and choose your spots. If I know a base model tablet is usually $199, I can choose to buy one at regular price or when it goes on sale for $99– like during Black Friday.
If I want to buy the latest model television (like a 4k resolution one), I can choose to buy one when it’s first released (supply is low and price is high), or I can wait until the prices for it drop.
It’s the same “good”– but wildly varied in price.
The difference is that most of the time you don’t resell many goods, while with stocks you can and probably do. The other difference is that these goods don’t create cash flows and don’t generally get more valuable with time. The underlying businesses behind stocks do.
You can choose to buy stocks with high valuations (high demand), or buy stocks with low valuations (low demand).
Oftentimes you can find stocks with similar past growth rates and wildly different stock prices due to demand. They could create similar cash flows and wildly differ in price. You could buy a business with billions of dollars more in assets than another at a cheaper price, again because of demand.
It all comes down to valuation at the end of the day.
And you can look at the history of any stock and see that the valuations constantly change. Look at a past valuation chart of a company like Microsoft, or Cisco, and see what happens when a high valuation pops (hint: the stock price crashes).
The point of all this is that you can buy a stock when it’s on sale or when it’s expensive. Because valuation constantly changes, your odds are probably better if you always buy particular stocks at lower valuations.
What Drives Valuations on Wall Street?
Again, the stock market is made up of buyers and sellers of businesses. If there are more buyers than sellers, the price of a stock goes up, and vice versa.
If there was a singular way to determine exactly how much a stock or business is worth, there wouldn’t be stocks going up and down. They’d stay at the same price, increasing predictably as the business improves or decreasing predictably as it does poorly.
Instead we see things like steep increases or dramatic crashes, which happen much faster than how the business is really preforming. It’s often amplified depending on market and economic conditions.
When it comes to determining the worth of a stock, which is an integral part of evaluating a stock…
…Beauty is in the eye of the beholder.
This difference in perception across investors and fund managers on Wall Street is what creates “good” stocks and “bad”. If you want to make money buying stocks, you’re gonna have to generally buy stocks that cost less than their real business’s worth. And you’re gonna want to buy businesses that will continue to do well.
What are some big picture ways we can buy more of these stocks at a discount to their real value? Let’s think through the stocks that get lots of attention on Wall Street and what they usually look like:
–High short term earnings/revenue growth
–Stocks with great chart momentum
–Bigger market cap stocks
–The newest technology stocks
Spend some time observing Wall Street and I think you’ll find it hard to disagree with the above.
Now, knowing that this is what Wall Street considers “beauty”, let’s think about whether it makes sense or not and how we can find our own measure of “beauty” to logically value stocks in a different way.
1. Focus on Long Term Metrics Rather than Short Term
The first point, earnings and revenue growth, is obviously important. This business growth drives stock prices up. Growth means rising real value.
But, Wall Street focuses on short term. If we focus on long term, we can find deals in stocks that are doing well long term but not necessarily short term, or just better long term vs short term.
Also, there’s other metrics that fuel this eventual earnings/ revenue growth. Like assets and book value. Less Wall Street focus on this can be an advantage to us if we look for it.
2. Ignore Momentum and Instead Look at the Business
Momentum has been proven through studies to not be a great representation of future performance.
In the cases it does, it’s likely more because the business is doing well.
Again, this is the concept of focusing on what’s causing the results rather than what are the actual results (like book value growth leading to earnings growth).
3. Buy Lower Market Cap Stocks When They Are a Good Price
It should be obvious that a stock’s size should have no effect on whether it’s a good investment or not. Rather, we want BUSINESSES with large size, not necessarily STOCKS.
Hopefully that makes sense to you. It’s the difference between a stock’s PRICE in the market rather than the business’s VALUE. That’s why I like to buy lower market capitalization stocks when the value is there.
By definition, these have less investors and less attention on them. Less analysts following them. Less fund managers investing in them. In fact, I prefer a stock with a lower market capitalization.
It can be a great opportunity. Just make sure the business is doing great.
4. Avoid Most New Technology Stocks
New technology has pretty much ALWAYS done poorly in the stock market.
Think about it. Every year there is new technology, just like every day has a new day. And while there’s excitement and great gains for new tech stocks in the beginning, they always seem to crash the hardest in the long term.
You can look at the dot com bubble and crash to see this play out, but it’s a tale as old as time.
Read The Intelligent Investor if you’re not convinced. Graham shares examples from the various decades of his time where new tech went from excitement to big bust and crash.
Logically, it makes sense. The excitement tends to overpower the business’s real value. While these new tech businesses may eventually have great business value, it’s hard at the beginning. Industries usually need to be reformed.
That takes time, and future profits doesn’t equal present value. Investors don’t tend to realize that, and bid up new technology stocks very high.
Just by avoiding these we can reduce the number of “losers” we buy. Wall Street’s trash is our treasure.
That’s 4 easy ways right there to be different than Wall Street, find treasure in the “trash” they are ignoring, and stay on the right side of a stock’s valuation compared to their business value.
How to Evaluate a Stock With Price-Based Metrics
Now that we understand the principles behind price, and have set big picture ideas on how we can stay on the “right side” of valuations, let’s look at a couple more specific ways to find stocks trading at great prices.
The most obvious and popular price-based valuation metric is the Price to Earnings, or P/E ratio.
Pretty much any financial website that allows you to look at the chart of a stock will also display the P/E ratio of that stock. The concept and formula behind the P/E ratio is simple.
The formula is: Price / Earnings.
A lower P/E ratio is what you want as an investor. A low P/E ratio can happen from either A) low price, B) high earnings, or C) both. Notice how all 3 of those cases are favorable. This is a good start to evaluating a stock.
Of course, if it were as simple as that, everyone who could do division would be billionaires from the stock market. There’s some differences between what makes a good P/E ratio and what doesn’t, which I’ve talked about before.
But understanding the P/E ratio is an excellent place to start when learning how to evaluate a stock, and it leads in nicely when your next step is learning about some of the other price based metrics (P/S, P/B, and P/C, for instance).
How to Evaluate the Business of a Stock
Looking at the price of a stock is a huge part of discerning the possibility that you are making a good investment when buying a particular stock. However, you also want to ensure that the company itself is solid.
I prefer to look at the balance sheet when it comes to evaluating a business’s financial health. Earnings, profits, and revenues can fluctuate so much more from year to year than a company’s assets, liabilities, and book value.
Assets are what create profits. You can think of them like the roots of a tree that eventually produce the branches, fruit, and leaves.
My favorite metric to evaluate this is the Debt to Equity Ratio. It’s also a very simple formula = Total Liabilities / Book Value. The lower the debt to equity, the better (in general).
Remember that a high book value comes from high amounts of assets.
A company with great assets but less than favorable earnings in the short term can be a fantastic opportunity in the long term because Wall Street is so focused on those short term earnings results. A company might stumble temporarily, but if its assets are generally great profit producers you can be confident in the business’s true long term health.
On the flip side, a company with low liabilities is generally less risky with a greater chance for compounding growth in the long term. When a business model doesn’t necessitate a bunch of expenses to create profits, a short term tumble in revenues or the economy likely won’t cripple the company’s long term results.
And when a company has low liabilities, it has more profits available that can be reinvested into the business to accumulate profit producing assets and spurn higher levels of growth over the long term.
As you can see, there are various components to evaluating a stock– but the basic concepts behind each are pretty simple.
The next step to understanding the concepts is finding the best ways to apply them, and its here where you’ll want to head to a company’s financial statements.
You can use metrics from the mainstream financial websites, but it’s really best to get your numbers from the source. Then you can calculate your own metrics and perhaps more importantly, see the trend of the business’s financials and how it has changed from year to year.
To do that, you’re going to want to learn how to read a company’s annual report (or 10-k).
It might seem like a lot to digest right now, but this is really the final key step to mastering and learning how to evaluate a stock. It’s in a company’s annual report where the true results of a business lie.
After that, you’ve really picked up a great skill that you can use for the rest of your investing life. Like the old saying, “Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime.”
An approach like this can really drive the difference between mediocrity and excellence in your investment results. Don’t take the advice lightly.