Investing Series: How and What Determines the Value of a Stock

This is a part of the Investing Series.

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I naturally do not claim to be a genius in stocks at all (I mean really, you should be suspicious of anyone who does), but I do know about stocks enough to give a basic overview.

Nothing fancy here, we won’t be talking about options or puts, as that’s for the more advanced crowd, and perhaps for a later post in the series if I can find a way to make it fun.

VALUING A STOCK IS PARTLY A GUESSING GAME

The first major point I want to make is that picking a stock is a bit like a guessing game.

It isn’t 100% fool-proof, and sometimes with estimations, you have to guess at what you THINK It might be worth based on your analysis.

As my finance professor once told me in school:

It’s really all up to what you think is going to be correct and if you have something to back up your assumptions.

I thought he was nuts, claiming that we could just pick numbers out of the air and it would be perfectly fine as long as we could justify them, but as it turns out, he was right!

For instance: Inflation — where your dollar is worth more today, than it is tomorrow, or in 10 years.

How can we know in advance what to put as an inflation rate?

We don’t know until the year is over, and hindsight is always 20/20.

Therefore, we use an average to stand in for inflation, such as 3%, which is an average over many years, taking into account that some years it was higher than 3%, and some, it was lower.

Or how about the fact that all of us are thinking about how much we might be able to have at the end of retirement, based on how much we’re saving now, namely the average rate of return on our investments?

We don’t bloody know!

So we use a range of 5% – 7% as an estimate of our returns over the long-term, to figure out how much we might have at the end after 40 years of saving.

You’re basically guessing at trying to figure out how much you need to save today to avoid eating cat food tomorrow, which is why I lower the risk of my guessing by putting the most conservative number (5%) possible as a rate of return, so that I push myself to save more money. Just in case.

Inflation and Rates of Return are some of the things we guess at for our finances, and stocks are no different.

Note: You can also check out this calculator by DQYDJ to help you figure out what stock returns you can expect when you invest in the general stock market.

WE HUMANS ARE IRRATIONAL, UNCONTROLLABLE HERD-FOLLOWING BEASTS

The second major point I want to make, is to be aware that we’re humans and not robots.

Photograph I took of a sculpture in the Louvre, in Paris France

We humans can’t be measured or controlled and we are irrational, panicky, optimistic and herd-following beasts.

As a result, since humans are the ones who trade on the stock market, the stock market (and its stocks) can perform in very strange, illogical ways that defy rationality.

Just look at basically every stock market crisis. EVERYONE KNOWS you should NOT panic, and just hold firm if you can (my sympathies go out to those who were in retirement and freaking out).

Instead what did most people do? They sold.

They sold everything as the market was crashing, thinking that they just NEEDED that money immediately before they lost everything.

Those who held firm through those shaky years, breathed a sigh of relief, because they made it through the storm.

Those who were smart, cash-rich opportunists, greedily bought at rock bottom prices and probably tripled their net worth or more.

Those who sold in a panic?

They definitely lost all that money by realizing their losses from cashing out.

Let’s not forget the rest of the things we can’t control, either, such as world economies.

Now put on top of that how the rest of the world is performing in terms of their economies, natural disasters and all these other things we simply cannot control, and we have what we can call a sort of managed chaos.

The stock market is a lot more about emotions and psychology than one might imagine, and I liken it to rich man’s gambling.

If you are not all right with such extreme emotions, and would rather have something stable and very comfortingly boring, then picking stocks may not be for you.

WHAT GOES INTO PICKING A STOCK?

There’s a lot that goes into stock picking, and it’s really a mixed bag:

• Stock calculations (also called “multiples”)
• Current expectations for the company
• Future expectations for the company
• The management of the company and their vision
• The industry the company is in
• The competitors the company is up against
• The stock market and the people who trade in it

We can definitely run plenty of stock calculations and multiples on each to get some hard numbers by which to screen stocks or rate them, but the final trick comes in trying to figure out what can’t be calculated.

My next post will go into how to do a few basic stock calculations in this Investing Series.

DON’T ASSUME ALL OF THIS IS ALL BLACK AND WHITE EITHER

Again, it’s a bit of a guessing game with multiples.

You may have to also adjust and account for the fact that a company has a higher ratio than its competitor because it is poised for some serious growth.

It’s a lot like trying to figure out what the right price for a house is.

Your real estate agent might take houses that sold in the area with similar properties such as the number of bedrooms, whether there’s parking, or public transportation nearby, and then take an average (or a weighted average) of those sale prices to figure out what the right price for YOUR house is.

Maybe you have a hot tub inside your house by a fire and no one else does!

That could be a major selling point, and be an \$20,000 extra on your list price.

Stocks are exactly like that — it’s all in relation to one another with exactly the same pricing cues to boot.

If you’ve ever read the book Priceless: The Myth of Fair Value (and How to Take Advantage of It), the premise of that book applies here in that people use pricing cues of other things to determine the “fair value” of a certain item.

TRYING TO FIND THE RIGHT STOCKS TO BUY IS LIKE DATING

When you’re trying to find the right stocks to buy, it’s called stock screening, or screening for stocks.

Screening for stocks just means you’re trying to find something that fits with what you are comfortable investing in terms of all the multiples listed above.

Think of it like when you’re dating and trying to find someone.

You’re meeting a lot of new people, and each new person you meet, you do a quick screen either in 10-minutes or over the course of 3 dates on them.

• Do they smoke? If yes, it’s a deal breaker for me (I’m extremely allergic and sensitive to it)
• Do they want to have kids? If no, it’s a deal breaker for me
• Do they like to travel & explore? If yes, it’s a big bonus for me because I enjoy traveling
• Do they seem responsible with their money? If yes, another big bonus. If no, it’s a red flag.

With the above information, you can figure out who might be a good fit for you in terms of values and compatibility for being a future partner, and from there, the field narrows.

With stocks, you can do the same screening with multiples entered into a website like Google Finance or Yahoo Finance, and screen for stocks that fit all of your exacting criterion.

Then when you get a shorter list of all the stocks that fit your multiples, the sifting and hunting through the list begins.

When you finally go through the entire list, you may end up with another smaller list, which you can start cutting down by eliminating certain (dying dinosaur) industries, or flighty ones like high-technology that you aren’t really thrilled about investing in.

From there, you may end up with a list of about 50 stocks on your Watch List, to which you can monitor the growth, and start reading up on each company to figure out if it’s a stock you can continue watching or to cut from the list immediately because you didn’t like what you read about the vision of the company.

BE AWARE THAT NOT ALL STOCKS ARE PUBLICIZED

Those sexy stocks like Starbucks, Google, McDonald’s, and Apple are the darlings of the financial world.

Everyone knows those brands, so people tend to follow and report on those companies the most because it’s recognizable and big.

Apple wasn’t even talked about until the iPod took off and started killing the market.

Before that, it was a stock that had slumped into low times back in the 1980s (December 1980, it was trading at \$2.75), buoyed only by a small group of loyal fans who couldn’t imagine using anything but a Mac.

Now? The stock is so hot, it’s ridiculous, reaching highs of \$700 due (partly) to some crazed Apple fever.

You have to be aware that a VERY small percentage of stocks actually make it to any kind of financial news realm.

No one wants to hear about let’s say, how great the zipper industry is doing, because NO ONE CARES about zippers (YYK for instance, is a privately-owned family brand, and produces almost all the zippers IN THE WORLD… let that sink in a bit).

Zippers are not sexy to most folks.

Coffee on the other hand, or a laptop, is a lot sexier and easier to imagine in your own life as a consumer, than zippers or the other hidden products of our consumer world.

This is why you need to employ the above method of stock screening based on what kinds of multiples in companies you are comfortable with investing in, to find those gems that most people tend to miss because they can’t be bothered to read about anything except what’s written in the financial media.

EVERYTHING THAT IS WRITTEN ABOUT A STOCK IS PURELY THAT PERSON’S OPINION

Ever read something like this?

Analyst So-and-So of some Big-Motha-Truckin’-Bank said that this Stock X will have an outstanding growth this year; says the company is poised to take over the world of fire-breathing dragons, so they’ve upgraded the stock to a Buy.

This is where you have to be suspicious of reading about stocks, even though the articles are full of what seem to be very technical and genuinely believable calculations about how this stock will rise and beat all the others.

Not all calculations are correct — you have to make (human) assumptions in some of them, so you can’t take everything at face value.

Lastly, it is all still the OPINION of the person who wrote it.

They can’t claim to know the future because they’re guessing just as much as you are.

BE SUSPICIOUS OF PEOPLE WHO CLAIM TO KNOW A WINNING STOCK

I am highly suspicious of ANYONE who claims they know how to best make money when in fact, they probably know less than I do. PF bloggers (partly) excluded, because some of them are just incredible with their wealth of knowledge.

In stocks however, everyone is guessing. Some guess better than most, but unless you’re Warren Buffett, you’re probably just an average guesser.

Bankers and money managers will always try and get you to give them money so that they can play with it on the stock market risk-free, then when they lose it all, they pull a sad face and say:

Sorry, the markets just weren’t making it happen like before!

You know who ends up being the donkey at the end of all that? You.

Don’t be the Donkey Dunce.

If you hear about a stock you think might be interesting, DO YOUR OWN RESEARCH.

Otherwise, you have no business buying stocks, and are probably better off putting all your money into index funds and leaving it to grow passively, but properly managed.

DON’T PLAY WITH MORE THAN YOU CAN AFFORD TO LOSE

If you can’t afford to lose your entire savings, don’t play with it.

The smartest investors are the ones who cherry pick from different investing strategies, and know their limits within each, and stock picking is one of the riskiest strategies out there if you don’t know what you’re doing.

Before you decide to sink your money into a stock, ask yourself:

Can I afford to lose all of this money tomorrow and still be all right?

If the answer is No, then don’t buy anything.

If the answer is Yes, then proceed with caution.

As a result, I play with less than 10% of my net worth in the stock market; so even if I lose 10% of my net worth, I’ll still have 90% of it left, growing steadily but surely for the very long-term (read: index funds).

SUMMARY

• Picking stocks is a guessing game with very smart numbers and fancy tricks
• Everyone is guessing just as much as you are, and even the numbers they’re using are guesses
• Ultimately, it is your money going into these stocks, so you better be aware of what you’re buying
• Not all stocks are publicized, only the sexy ones like Google, Starbucks or Apple are
• Pricing cues will also tell you what the stock MAY be able to achieve due to human irrationality
• Never play with more than you can afford to lose
• Be suspicious of self-proclaimed rainmakers
• If all of this stock-picking gives you hives, put your money into index funds

• PK

“PF bloggers (partly) excluded” – Hopefully even the good ones are hedging their bets a bit, haha.

I love the one you linked to – I wish that piece had more activity, versus the S&P 500 one (where you have to pick the time-frames). You’d think me collating EVERY time frame through December 2012 would be enough, eh?

• saverspender @ save. spend. splurge.

Well it’s hard to get people excited over calculators 🙂

• StackingCash

I love this post because it gives the cons in picking stocks. Too often, people get so greedy and try to pick hot stocks, not realizing the consequences of their choices. I wish I had this advice 20 years ago. It would have changed my life tremendously.

• saverspender @ save. spend. splurge.

I’m glad to hear that I’m offering correct advice then! Thanks for the validation 🙂

This is just based off my observations on stock-picking, and people/investor emotions when it comes down to it.

It can be VERY easy to be swayed (I was burned once or twice, small amounts about \$500 – \$1000 for crap, exciting stocks).