Saturday, August 20, 2011

Lesson 1: Evaluating A Stock, A New Perspective

We all know of a corner grocery store near where we live. You know, the one that's family owned, been around since you were born, and survived through multiple market crashes and recessions. To keep the numbers simple, let's say that this business makes $3 per year. After restocking inventory, paying the delivery man, paying the clerk, rent for the location, accounting for theft, etc, we have a profit of $3 each year. It sees the same customers every week. It's guys like you and me buying our weekly amount of milk, cold cuts, junk food, cereal, maybe soap. It's fair to assume that this grocery store will operate the same exact way every year for the foreseeable future, regardless of if China goes to war, or if the US debt gets a downgrade.

Now, the million dollar question.... How much would you buy this grocery store for? $1? $100? $1 million? The real question here isn't how much you should buy it for. The real question is, how do you make $3 per year? Well, if you put $100 in a savings account that gives 3% interest per year, you'd earn 3 dollars per year. From what I've seen, banks are pretty safe. I've never owned a business before. If I have to choose between making 3 dollars from a bank and 3 dollars from a grocery store by using a 100 dollar investment, I'd stick with the savings account.

For some of you, this might be the moment of enlightment! By comparing a company to earning interest on a savings account, we've just established a maximum price that we should pay for this grocery store. If we buy this grocery store for $100, we would earn the equivalent of a 3% interest, which is unattractive due to the amount of risk that you take compared to getting 3% from a savings account. What if you can buy this store for $10? $3 of profit per year for an investment of $10 is an equivalent of 30%. I doubt you'll find a savings account giving 30% interest. At 10 dollars, this grocery store is very attractive. If you were in fact able to find a savings account paying 30% per year AND is FDIC insured, $10 for this grocery store is not attractive at all. Whether or not this deal is a good one depends on your alternatives.

Let's take this a step further. Let's say that this grocery store decides to become a corporation and issue stock. It decides that it only wants to issue one share of stock. Is there really a difference between owning a business and owning this one share of stock? No! It's the exact same thing! I know a few business owners and managers. It appalls me how they can own and run a successful business, but when it comes to investing in stocks, they don't realize that it's the same exact thing. If you bought the store at $10 and suddenly the recent mortgage crisis causes a drop in all stocks, would you consider selling your store at $5? You shouldn't! If it was a good deal at $10, then it's an even better deal at $5! At $10, it was a 30% rate of return. At $5, it's a 60% rate of return. As long as the store operates in the same way and continues to generate $3 a year in profit, you should remain confident and not worry that someone else offers to steal a bargain from you.

Let's get this straight. Not every business is as simple as a grocery store. However, there are businesses out there that operate as simply as a grocery store. Maybe the business is actually a bit more complicated, but it is simple to you because you understand it well. These are the businesses that are good investments. The simplicity of a grocery store allows me to shrug off anyone's argument that the US Credit downgrade can possibly affect this store. This is the same store that has been through 2 world wars, the Great Depression, and multiple recessions. It will be the same exact business when all of today's news and hysteria blows over. It's not as easy when you think about Exxon Mobile. Politics, foreign exchange, interest rates, wars, and even individual greed will affect the bottom line of Exxon. You may be well versed in this area and it may make plenty of sense to you. But it's not for me.

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