There are two kinds of people who leave Las Vegas. The smaller group has preserved some of their winnings. The rest only have a story. As strange as it may seem, many of the most enthusiastic participants in the markets can be generally divided into similar groups. Those who look at the market as a place to make bets in the hope they will “win” usually end up part of the larger group. The others eschew bets in favor of investments.
The stories the first group tells usually involve stocks that have slid in price, sometimes so far they end up taking losses they never expected. “It was such a hot stock!” they complain. “How could it have lost so much so fast?”
The answer to their problem is as plain as day. They overpaid. The practice of not overpaying is what they are missing. There are so many names for this practice that it is easy to become hopelessly confused, so it is probably advisable we leave it without a name for the moment. The technique itself relies on a very simple principle, and that is to pay no more for an asset than it is worth. When an investor overpays, they are simply pitting themselves against time to see whether their negative equity can be overcome before they need their savings. When the right price is found, however, the power curve flips and what could have easily been lost money becomes positive momentum. If you want to avoid the overpayment trap, here are some things to consider.
What Is The Company Worth?
Every amateur accountant knows the central equation of the balance sheet: Assets equal liabilities plus equity. The principle is that the two values on opposite sides of the equation must always balance. At least that’s what the accounting department prefers and what the general ledger demands. But what if they don’t?
For an investor, the equation can be rewritten as Equity = Assets minus Liabilities. Equity is the combined stock value. If the stock value, or total equity in a company is higher than assets minus liabilities, then the stock is overpriced. In other words, new stockholders are being asked to pay a premium over the actual bankable value of the enterprise on the day they invest.
On the other hand, if equity is less than assets minus liabilities, it means the stock is underpriced. Why? Because if an investor were to walk in and buy the company, break it up and sell off the assets and pay all the liabilities, they would be left with more money than when they started. The total amount they paid for the stock would be less than they could sell the company for.
The Variable
Knowing what a company is worth isn’t as difficult as most financial professionals would like everyone to believe. Publicly traded corporations are required by law not only to publish their financials every quarter, but also to publish a balance sheet which clearly spells out what a company owns, what they owe and to whom, and how many outstanding shares of stock there are. From that information alone, it is possible to determine the legitimacy of a stock price.
But there is more to a corporation than its equity value. Every quarter, a corporation also publishes a profit and loss statement and notifies investors and the general public about its earnings. How much income the company had, how that income compares to previous quarters, and how much is being spent factor into a stock purchase decision too, especially if there are dividends or preferred shares to be had. If shares of a company’s stock are trading at $40, and each share is throwing off a $.40 dividend every quarter, then time becomes a factor in the purchasing decision. Even if the shares are overpriced relative to the corporation’s assets, they are generating 4% income every year. If the shares are overpriced by say, 10%, as long as that dividend is coming in, the difference between equity and assets will be paid for in less than three years. All the dividends after that are pure profit.
The Decision
Far too often, investors fail to evaluate these simple metrics in favor of whatever measure they believe is a more accurate barometer of a company’s ability to make money. While it is true some investments are optimistic “bets” on the future of the enterprise, far too many of those investments are treated like venture capital by people who are not in a position to take that magnitude of risk. Retirement accounts, pension funds and family nest eggs require a more cautious approach, even if those investors find they don’t get the outsized returns they read about in the breathless reports of skyrocketing small caps and technological triumph.
In the process, the less risk-tolerant investor overpays, tacks on a few fees, misses the dividend entirely and finds themselves in a five year race to get back to parity instead of adding to their hard won salary and other earnings.
This kind of thinking is like the running game in football. It’s not sexy but it’s got teeth, and employed properly it can be a formidable weapon in the battle to preserve wealth. Ultimately, the quality of every investment decision will eventually come down to math, and in an age where there are billions of electronic computers on the planet, there is no excuse for any investor to not know with precise exactitude how their numbers compare to those of investors who aren’t constantly fighting gravity.
Paying exactly what a stock share is worth is how investors trade gravity for wings.