So you want to buy a stock. Or in my preferred terms, you want to become a part owner in an ongoing business.You’ve opened your retail brokerage account, dumped a couple thousand in it, and you’re ready to pick a few publicly traded companies to buy shares in. The question you want to answer though, is which makes a good buy and how much is a good price to pay for it?
I’ll attempt an answer that has worked for me. It’s a combination of numerical/statistical considerations, and qualitative or value judgements that you have to make for yourself. In this case, my assumption is that you want to stay invested in this company for a very long time.
The first question is: what kind of business does the company do? You want something with staying power, a business that will still make money for you ten, twenty years in the future, not just today. Since I’m currently in the process of evaluating their company, I’m going to choose ExxonMobil. They’re a large company, they hold oil producing property in nearly every country that has one, they have an excellent management, make money even with oil at $40 a barrell and, even though alternative energy is gaining steam, I’m fairly confident that even fifty years from now, people will still be pumping gas for cars, machines, planes, plants and more, throwing off earnings to Exxon, some of which will come back to me.
Having decided that you like their business, the second thing is to explore their financials to figure out how much money you actually expect them to earn. Currently, Exxon’s stock price is $89.72. Their earnings per share (which is simply their total net income, divided by the number of shares) is $7.95 which means if you buy their stock today, you will be making around 8.8% of your investment annually. Around 35% of those earnings will be mailed to you as dividends to do whatever you want with, while the balance is reinvested to keep the business growing at a relatively stable 3-5% annually, which is still ahead of inflation.
Now, look at that proposition. Your return on investments on an earnings basis is 8.8% today. Inflation is only 2% while the company is estimated to grow at 3-5%, adding an additional 1-3% return post inflation to your original 8.8% ROI. In less than 8 years, all the money you paid for the stock will have been returned to you in earnings and dividends and all other money the company makes for you becomes your growth in wealth. Spread this among enough companies, throw in compounding, and over time, those gains really start to add up.
All this, of course have focused on the earnings and dividends coming directly to you. I’ve said nothing of the capital appreciation of the stock price, which is the one metric everyone judges a good stock by. Even the greenest novice knows that it’s a good thing when your stock goes up. I deliberately left this for last for a few reasons. The first is that if you’re trying to build a long term portfolio of business equity, it pays to act like you’re going to hold those stocks forever. The rise and fall of the stock price does not affect you unless you decide to sell and cash in a profit. Otherwise, in good times and bad, all that matters is your earnings.
The second reason is that most stock prices tend to track earnings in the long run, but in the short run a million things drives the prices from some shareholder deciding to dump their positions, bad news about the company, general behavior of indexes to which the stock might be added on, and many other technical and demand/supply considerations that mostly only make sense if you’re an active trader. However, it is still possible to estimate an instrinsic value which the stock should trade at, to see if it’s trading much lower than that. That helps you buy at a better time, and adds to your total return.
In this case, ExxonMobil at $89.90 is trading at about 11 times it’s annual earnings per share. With $41 per share’s worth of net assets,moslty cash, currently owned properties, and developing projects, and the earnings yield, I peg their intrinsic value at somewhere around $140 and increasing. The calculations I used for that include accounting for current interest rates as well. Naturally, I have no idea if the stock price will get back up there, but if it does that will be a nice bonus.
Since I came to that conclusion, I initiated a direct purchase plan, investing around $250 a month into the stock by buying from the company directly, instead of going through a broker. By spreading my buying across several months, I will take advantage of any further declines in their stock as oil keeps tanking, and hedge any risks of buying at the wrong time. I will from time to time, provide updates on how that is going.
Ask me questions in the comments below, and I will try to answer them in detail.