The Importance of Price and Value in Investing

Our investment process is based on investing in good companies at prices that are a significant discount to their fair value. We plan to hold these investments for a long time. Typically, that period is at least five years, and often much longer. Our goal is to create long-term investment returns that significantly outperform market averages.

Understanding the relationship between price and value is the most important part of our process. Price is what we can buy something for today. The stock market allows us to see the price we can buy or sell each stock for every day.

Value is what something is worth today. Price often changes frequently and significantly and is often short-term focused, while value typically changes infrequently and gradually and is long-term focused.

Investors often get caught up in manias or depressions based on short-term events. This leads to stock prices that are far too high (manias) or far too low (depressions) versus the underlying value of a stock. This happens because investors are human and we get carried away by our emotions.

Estimating Future Annual Returns for Stocks

To estimate future annual returns for a stock, we need to understand three things:

1)      How much profit a company is currently making per share of its stock

2)      How much it’s likely to grow those earnings over time

3)      The value investors are likely to place on 1) and 2) over the long-term

Understanding 3) is the most important (and difficult) part of this process.

(1) Earnings Per Share and Earnings Yield

All public companies are required to produce quarterly and annual earnings reports. These reports are standardized and give us the most recent years’ earnings per share. We take the earnings per share and divide it by the current stock price to get a company’s earnings yield. The earnings yield is the annual return current earnings are giving us as a percentage of the current stock price. This is the annual return we can expect to receive today.

Example: If a company is earning $1.00 per share and it costs $20 per share to buy their stock, then their earnings yield = 1.00 / 20 = 5%. We will receive 5% on our $20 investment over the next year based on the company’s current earnings.

(2) Growth in Earnings Per Share

We can see how a company has grown their earnings each year in the past which gives us some insight into their ability to grow future earnings. But that’s not a complete picture. We conduct in-depth research to develop a thorough understanding of a company, creating a more complete picture and enabling us to better estimate their future growth in earnings. This gives us the additional return we can expect to receive each year in future. It adds to the earnings yield in (1).

Example: If our research shows that a company is likely to grow its earnings per share by 5% each year, we use 5% as our growth in earnings per share.

(3) Quality of Earnings – The Price to Earnings Multiple

We need to understand the quality of a company’s earnings. With in-depth research we can understand how highly (or lowly) investors are likely to regard a company’s future earnings. Stock markets have a long history that shows what investors are willing to pay for certain desirable characteristics. Companies with desirable characteristics are valued more highly than ones without them:

a)    Quality of earnings – are earnings likely to be stable and consistent or volatile and erratic? Are profit margins high or low? Are profit margins likely to increase, decrease, or remain the same?

o   Desirable = stable/consistent earnings, combined with high and stable/increasing profit margins

b)   Growth in earnings – are earnings likely to grow significantly, minimally, not at all, or will earnings shrink?

o   Desirable = high likelihood of significant long-term growth

c)    Company reputation – is this a company that people strongly desire to be associated with? The quality and growth of earnings help with this too

o   Desirable = people think very positively of the company

We consider how desirable a company is to help determine how highly investors are likely to value their future earnings. This information guides us to an estimate of the Price to Earnings Multiple for a company’s stock. We can then compare our estimate with the current Price to Earnings Multiple to see if the stock is priced cheaply, expensively, or fairly. If we can buy a stock at a discount, we can earn higher returns, above and beyond what we get from (1) and (2).

Example: If a company’s current Price to Earnings Multiple is 5 and our estimate of the long-term Price to Earnings Multiple is 10, the company is currently half price. If our estimate is correct the stock will double in price in future.

(4) Calculating Future Annual Stock Returns (Over the Next 10 Years)

We add our answers from (1), (2), and (3), to get an estimate of future annual stock returns:

 (1) Earnings Yield + (2) Growth in Earnings + (3) (Change in Price to Earnings Multiple / 10) = (4) Estimated Annual Stock Returns

(3) = (100% / 10) = 10%

(1) + (2) + (3) = 5% + 5% + 10% = 20% Estimated Annual Stock Return

In (3), we are saying it may take up to 10 years before investors fully recognize the company’s long-term value (a very conservative estimate). If it takes less time, the annual stock return will be higher for a shorter period of time.

What is a Company Worth?

Using the process in (3) above, we get an estimate of what a company’s stock is worth. Its value. Calculating (1) and (2) helps us to develop an understanding of the annual return we can receive while we wait for the current value to move back towards its long-term value. In this example, we receive 10% per year while we wait and (at least) an additional 10% per year as the value returns to normal.

The Benefits of Understanding Value

Understanding what a company’s stock is worth, and a reasonable estimate of its annual stock return is an essential part of making good investments that can outperform market averages. The high degree of analysis we perform on every one of our investments gives us the confidence to buy and hold stocks even when they are out of favor. It also provides us with a roadmap for when to sell a stock as well.

Investing Terminology

Public Company – a company that has sold stock / ownership to the public

Stock – an ownership stake in a publicly traded company (traded on stock markets)

Shares – the amount of ownership we have in a publicly traded company. E.g. owning 100 shares of stock in Google is an ownership stake in Google

Earnings – the total profit that a company produces each year, which we, as the company’s stock owners, are entitled to a portion of

Earnings Yield – the percentage amount of earnings an investor receives each year based on the purchase price of a stock

Earnings Growth – how quickly a company can grow their earnings (profits)

Price Earnings Multiple (P/E) – how many times the current market price of the stock is above the annual earnings per share. E.g. if the market price of Google stock is $200 and each share is earning $10 per share = Market Price of Stock / Earnings Per Share = 200 / 10 = a P/E of 20

Fair Value – this is what we consider to be ‘Value’ – what a stock is worth today regardless of the price we can buy/sell it for in the stock market

Market Value – this is what we consider to be ‘Price’ - the current value based on the stock price in the stock market