It's Time to Change the Way You Think About the Stock Market
InvestorEducation / Learning to Invest Apr 07, 2012 - 01:31 PM GMTBy: DailyWealth
The Daily Crux: What does it mean to value a stock as a business? How does it differ from the way most investors think about investing? Dan Ferris: Let's start by considering what a stock actually is. In simple terms, a share of stock represents a share of an actual business.
But as Warren Buffett says, most people tend to think of a stock as a ticker symbol with a squiggly line attached. Most people think it's easier to look at a stock chart and try to predict whether its price will go up or down than it is to understand the underlying business. But the truth is, almost nobody is good at this. It takes an extremely rare individual to do it with enough consistency to make money.
Some professional and dedicated part-time traders succeed by buying and selling stocks using short-term strategies. But the overwhelming majority of investors would make a lot more money – and lose a lot less – if they learned to approach stocks the way they'd approach ownership in a business.
You're much more likely to find a business that's simple enough to fully understand than you are to consistently predict where the price of a stock is going next.
Crux: What are the benefits of approaching investing this way?
Ferris: There are a number of benefits. Several of the world's greatest investors have shown this approach is one of the simplest, safest, and most consistent ways to make money in stocks. But perhaps even more important is the peace of mind it offers. Let me give you an example...
Suppose there are two investors who are buying stock. For the sake of this example, let's even assume they're both buying stock in the same company, XYZ.
Investor A approaches investing as a business owner and does a little homework on the underlying business. He sees company XYZ is a wonderful business trading at a good price, and he buys a sizeable position.
Investor B is like most people and decides to buy XYZ without any real understanding of the underlying business. Maybe he saw the stock being touted on CNBC, heard this or that famous investor was buying it, or has a friend who made a lot of money in it.
If that stock goes up, both investors will probably be feeling good about their decision. But what if the stock was to suddenly fall 5%, 10%, or more? Or the market experiences a serious correction that takes most stocks down with it?
Investor A is much more likely to sleep well at night. He knows he bought a quality business and he knows he paid a good price for it. He knows the fluctuations in the share price have nothing to do with the underlying business. In fact, he may actually be happy to see the price fall – as Warren Buffett likes to say – because it will allow him to buy more shares or reinvest his dividends at a better price.
On the other hand, Investor B would probably be concerned. He has no idea what the underlying business is actually worth or what a fair price for it is. He only knows that he's lost money. He's probably wondering whether it will be a 5% correction or a 30% crash and whether he should sell now or wait it out.
The fact is, you can't know those things in any kind of reliable manner. But you can know that great businesses consistently make money through good times and bad. And you can have a lot of certainty that over the long run, you will be rewarded as a shareholder.
Just look at the history of the 20th Century... What calamity didn't happen in the 20th Century? We had two World Wars and a handful of smaller ones, a Great Depression, and great inflation. All the gold in the country was seized by the government, the dollar was taken off the gold standard, and we had 50%-90% marginal tax rates for many of those years. Yet over the century, the Dow Jones Industrial Average soared 1,500,000%.
Of course, you could argue that companies would have done even better without those government-created problems. But the point is, business trumped politics, wars, the economy, and inflation. There are never any guarantees in the stock market. But betting on great businesses was always the right thing to do over the last 100 years. And there is a very high probability that you'll do well buying great businesses over the next 100 years.
Crux: How does an investor begin valuing stocks like a business owner?
Ferris: The first step is as simple as changing your thinking... It's deciding you won't buy a stock unless you can understand its business, it looks attractive, and it's reasonably priced.
Most folks would intuitively understand this if they were buying an actual business outright, but they seldom make the connection when buying stocks.
The first thing you'll notice when you begin thinking this way is, very few stocks are likely to meet those criteria. When you really understand what you're buying, you'll tend to be much more selective and gravitate toward great businesses.
Crux: Are there any simple ways to identify a great business?
Ferris: There are a few clues great businesses leave behind. The easiest one to identify is a profit margin of consistent thickness over many years, even if it's a thin profit margin.
For example, Wal-Mart's net profit margin is thin, around 3%. But it's a very consistent 3%. It's in the 3% range every year like clockwork. Microsoft's gross margin has been around 80% for many years. Most great businesses earn consistent profit margins.
Consistent margins tell you that something special is going on there. That business has been able to extract that profit out of the market because it's doing something that people really want year after year after year... And it has positioned itself in the marketplace so that it can keep doing it.
Another big clue of a great business is consistent free cash flow generation. That's a sign that the business doesn't require all kinds of expensive reinvestment year after year. It means the business can invest relatively little of that cash profit and put the rest toward things like paying out dividends, buying back shares, or making new investments in the future. A business gains a great deal of flexibility when it's able to generate a lot of free cash flow.
A third clue is a history of dividend payments that rise every single year for many years on end. Not all great businesses have this trait, but many of them do... so it's something to look for.
There are obviously more, but these are the big ones that most great businesses share.
Crux: Once you've identified a great business, how do you determine if it's trading at a good price? How do you value the business?
Ferris: There are two primary ways to value a business. One is by net worth, and the other one is by profit generation.
Net worth is calculated the same way you would do it for yourself. If you want to find out what your net worth is, you add up all your cash and all your assets, like your house, your cars, etc. Then you subtract everything you owe – things like your mortgage, your credit cards, and your car loans – and that difference is your net worth.
You can do the same thing with a company. You can look at a company's balance sheet and assign a value to its cash and other assets, add them all up, subtract what it owes – debt and other liabilities – and you get its net worth.
This is a simple example. This calculation can get rather complicated, depending on the business. Sometimes, assets have to be revalued, for example, if the company owns a bunch of land that they paid very little for many years ago that's worth much more now. But the basic idea is the same.
This measure of value is best-suited for asset-heavy businesses or strict value investing situations – where you're buying $1 worth of assets for a significant discount and waiting for the market to fairly value it. Fair valuations will vary significantly, depending on the industry and the situation.
The other way to value a business is based on profit generation, or how much free cash flow the company produces. This tends to be a better measure of value for really great businesses... businesses that you're confident are going to make more money next year, five years from now, and 20 years from now.
We can look to history for a benchmark for valuing these great businesses. When companies have bought out or taken over really great businesses in the past – for example, when Mars bought Wrigley's, InBev bought Anheuser-Busch, or when Procter & Gamble bought Gillette – they've tended to pay right around 30 times free cash flow.
So generally speaking, if you can find one of these really great businesses trading for around 15 or 16 times free cash flow, you're probably getting a really good deal that you should buy and hang on to for a long time.
Of course, there's much more to valuing companies than we can explain here, but this will get you started. If you're interested in learning more, there are some great books on the subject like Joe Ponzio's F Wall Street and Joel Greenblatt's The Little Book That Beats the Market. Ben Graham's classic book The Intelligent Investor can't teach you how to value a business, but it can teach you how to make sure you don't pay too much for any business... or generally become bullish or bearish at the wrong times. I also spend a great deal of time explaining these topics to readers of my 12% Letter and Extreme Value advisories.
Crux: Any parting thoughts?
Ferris: I think there's a temptation for investors just learning to value businesses to focus on the "net worth"-type companies I mentioned earlier – the so-called "deep value" stocks – because they can appear to be much easier to value correctly.
But what you'll come to realize is many of those situations don't work out very well. Oftentimes, what you're really doing is buying a bad business that may be on its last legs.
So after a while, many value investors decide they don't want to buy lousy businesses anymore. They decide they would rather buy great businesses that are going to maintain and grow their value for a long time.
That's a typical transition for a value investor to make... and one I've made myself. In fact, Warren Buffett himself made this transition over his career. I encourage new value investors to keep that in mind.
Crux: That's a great point. Thanks for talking with us.
Ferris: My pleasure. Thanks for inviting me.
Editor's Note: Dan Ferris is one of the greatest value investors we know... But he's also an expert at helping folks find safe, reliable streams of retirement income. Dan recently uncovered an opportunity that could potentially double or triple your retirement income, thanks to a controversial decision by former president George W. Bush. Click here for the details.
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