I was with a friend the other day I haven’t seen in a while.
I was talking to her husband about stocks, and she chimed in and said, “It all just seems like gambling”.
And for most people, she’s right.
Most people buy stocks for reasons like:
- “My friend bought it”
- “The price is down so it’s cheap”
- “The price is up so it should keep going up”
- “I heard this guy on Instagram talking about it”
Of course, none of these are valid reasons to buy a stock.
This is the equivalent of saying something like, “I bet on red because my friend bet on red”, or, “I bet on red because it landed on red last time.”
Whenever you buy a stock, you shouldn’t think of it as a stock.
Think of it as buying a business, because that’s exactly what you’re doing.
Even though you may only be buying a very tiny percentage of a business, the process is exactly the same as buying an entire multi-million dollar business.
To illustrate how this works, let’s forget completely about stocks for a minute.
Let’s just say, you’ve inherited a few billions, and you’re interested in buying a business.
You go to a business broker and he presents you with these 3 companies for sale:
Profit: $4 million/year
Price: $180 million
Profit: $12 million/year
Price: $680 million
Profit: $60 million/year
Price: $350 million
With some quick maths, we can deduce the following:
- If we buy Company A, it will take us 45 years before we recoup our investment (getting back $180 million at $4 million per year).
- If we buy Company B, it will take us 56 years to get our investment back.
- If we buy Company C, it will take us 6 years to get our investment back.
Based off this alone, which company would you want to buy?
Probably Company C, right?
Plot twist: These are actually numbers from real stocks.
Company A is Netflix.
Company B is Tesla.
Company C is Sky TV.
(I changed the “billions” to “millions” for Netflix and Tesla to make the comparison more sensical).
Now – if I had asked you off the bat, “Which stock would you rather own – Tesla, Netflix or Sky TV?” I’m sure most would not have chosen Sky TV.
But, if you stop thinking of this decision as simply “buying a stock” and instead understand you’re buying an actual business, how would your thought process change?
You would ask the questions you would ask when buying a real business in real life:
- “How much will I pay for the business?”
- “How much profit does it make?”
- “How long will it take me to recoup my investment?”
The great thing about the stock market is, you can find out this information instantaneously, for every single listed company.
The problem is – most people don’t!
Everybody wants to buy Netflix, but if you asked them, “Would you buy a stock that would require 45 years to make your investment back?” they’d probably say no, even though that’s exactly what they’re doing.
Of course – I am simplifying things.
Buying businesses is much more complex than these two or three questions.
For example, Netflix will possibly experience a lot of growth, whereas Sky TV probably won’t.
But how much does that change the equation?
If I asked you – “Would you buy a stock that would require 45 years to make your investment back, but there’s a possibility the company’s revenue will grow a lot in the future, so *maybe* if things go well, it might only take 10 or 15 years to make your money back?”
Would your decision change?
I’d still buy the company that will earn my money back in six years – Sky TV.
There’s certainty. After six years, I can relax. I don’t need to wait 20 or 30 or 40 years, hoping the company stays profitable and the industry doesn’t change radically, or something like AI or VR doesn’t disrupt the industry. I’m not relying on imaginary growth in the future, I can rely on the reality of right now. I will sleep easier. I’m getting much more value for money.
If this is the way you would think about buying a company, why isn’t it the way you think about buying a stock? They’re exactly the same thing.
How To Find Out This Information?
All this information is publicly available and can be found in a few seconds.
All you need is an understanding of some basic accounting lingo, which I’ll explain to you right now.
Step 1: Profit
How much money does the company earn?
This is known as “net profit” or “net income”.
You can find this on the Statistics page on Yahoo Finance.
Step 2: Price
Next, we need to see how much we’re paying for the company.
Many people mistake the share price as an indicator of value.
“Wow – the share price is $1,000! It must be a valuable company!”
The reality is – a share price is a completely useless piece of information.
It tells you almost nothing.
For example, if the share price is $6, what does that tell you? How much is the company worth?
You have no idea.
What you need to do is take the share price and multiply it by the number of shares.
This will give you the value of all shares.
The value of all shares tells you the value of the company!
This is known as the market capitalization, or “market cap” for short.
You can find a company’s market cap on its Yahoo Finance page:
Step 3: Work out the multiple
Now we have the two pieces of information we need to get an idea of how much we’re paying for the company.
As we found out in Step 1, Netflix makes $4 billion per year.
As we found out in Step 2, Netflix is selling for $180 billion.
Which means we are paying 180/4 = a multiple of 45 for this business.
This means it will take 45 years before it earns how much we paid for it.
But wait! It’s not that simple
Once again – this is much more nuanced in reality.
For example, what if Netflix manages to double its profit every year?
- This year: $4b
- Next year: $8b
- Year 3: $16b
- Year 4: $32b
- Year 5: $64b
- Year 6: $128b
This means it would only take us 6 years to make our money back and more.
However, you already know this won’t happen (Netflix doesn’t even double its profit right now during its growth phase, so it definitely won’t during its maturation phase). And, even if they signed up all 8 billion people in the world, at $10/month they would still only make $80 billion in sales. Meaning $128b in profit is practically impossible.
You also need to consider what happens if it goes the other way. What if streaming becomes so competitive that they never manage to grow profit again? Instead, profit falls by 10% per year for the next 20 years?
That means it will take you far longer to get your money back – maybe 80 years.
So the question is – what do you think will happen? How much will Netflix need to grow its profit for it to be a suitable investment for you? And how likely do you think that is? That’s your job to decide as an investor.B
Breaking down these basic numbers is the first step of stock research, and what I look at before looking at anything else.
The tool I use is Simply Wall St, as it very conveniently lets me get all this information in one screen:
As you can see above, I can immediately see the current net profit and market cap. From there, I can work out in my head a rough multiple in a few seconds. I can also see the revenue and profit displayed graphically for the last 10 years, which immediately gives me an idea of how much profits might grow (or fall) in the future.
This means I can make a snap decision in about 10 seconds on whether I should research a stock further, allowing me screen hundreds of stocks in a day if I need to.
The goal is to find a business selling at a reasonable multiple, with healthy profits (either stable or growing), and a business that makes sense to me. In other words, a business I would like to buy in the real world!
From there, I will research the other things that the company’s success depends on, such as:
- The CEO
- The board of directors
- The product
- The competitors
- The industry
- Customer reviews
- Cash flow
All of these are things you would look at if you ever purchased a business in real life.
This means you should also look at all these things whenever you invest in a stock!
Remember – buying a stock is simply buying a piece of ownership in that company.
Treat it like you would any other investment decision.
Would you spend $100 million to buy this entire company?
If not, you shouldn’t be spending $100 to buy some of its stock either.
In both instances, you’re buying the business, so the decision process should be exactly the same.
Want To Learn How To Find Great Businesses?
All of the above and more is taught in my course Simple Stocks.
The stock-picking process is broken down into easy-to-understand lessons that teach concepts like those above so you can become a better investor.
Looking for businesses to buy is one of my favourite things to do and I do it daily!
You can learn everything about the course by clicking here!