Sunday, August 19, 2012

Investing Tutorial - Part 1 (Stock Valuation)

Benjamin Graham - the mentor of Warren Buffett, one of the world's richest men and greatest investors - wrote in his seminal treatise on investing, that the difference between an investment and speculation is that an investment is something that after thorough research provides safety of principal and an adequate return. Anything else, Graham warned, is speculation.
[CD] Security Analysis By Graham, Benjamin (Google Affiliate Ad)

In the Investing Tutorial Series that I am starting today, I will be discussing basic investment tenets that will hopefully help my readership take their financial destinies into their own hands. Today's topic is stock valuation. And crucial to the topic of stock valuation are the two primary principles behind why anyone would invest in the first place: 1) to combat the corrosive effects of inflation; 2) to take advantage of the benefits of compound interest. Let's tackle these two concepts briefly before getting a little into the weeds with stock valuation.

When governments print money to satisfy their own financial obligations, or banks make it easy for people to borrow money, the amount of money in circulation increases. When the amount of money/currency in circulation in a particular economy increases, the value of that currently goes down. When the value of currency goes down, prices go up to make up for the fact that the value of goods and services  being provided has remained relatively stable. Humans invest in the stock and debt markets in search of investments that will exceed the rate of return on "risk-free" assets (assets on which you will not lose money) like U.S. Treasury bonds.  By finding these investments - assuming that they go up in value - investors can assure themselves that their purchasing power will at least keep up with inflation, thereby enabling them to maintain their present standard of living in old age.

With regard to the second principle behind why we invest, Albert Einstein once said, "Compound interest is the eighth wonder of the world. Those who understand it, earn it...those who don't, pay it." Compound interest, for the uninitiated, is the interest that accrues on principal (the initial amount invested) and the interest  that had previously accrued. The chart below demonstrates the power of compound investing:

 
Here, $1000 and nothing more is invested over the course of 10 years and the various lines demonstrate what happens at different interest rates. It's not important now, but if you want to know how to calculate compound interest, here's a formula:  F.A. = P * (1 + I.R.)^N, where F.A. is the final amount including principal, P is the principal amount, I.R. is the interest rate used for compounding in decimal format, and N is the number of years the principal has been invested.

So, how does all of this relate to stock valuation? Well, remember how Graham said that an investment involves safety of principal. Another way of saying keep your principal safe is "don't lose money"! Graham isn't telling us not to lose money just because losing money is no fun. He's telling us this because when we don't preserve our principal, it is harder to take advantage of compounding interest and thereby combat inflation. Here's an example.

Suppose you have $10,000 to invest and your husband's friend comes along and gives you a "hot" stock tip. You oblige and plunk $10,000 of your hard earned money into this stock as an "investment", but because you didn't do as Graham advised in failing to research this stock, you lose 50% of your money and this investment is now worth $5,000. In order to just get even, you have to earn a 100% return. Let's say you lost 25% instead and your investment was now worth $7,500 instead of $10,000. You would have to earn a 33% return in order to get back to even.

The moral of the story is that capital preservation is key in any investment undertaking. After realizing that not losing money is key, the next step in analyzing an investment is determining its value or how expensive it is. Determination of an investment's value determines whether or not you will be preserving your capital, and on your way to capital appreciation, as opposed to placing your capital at risk of permanent loss. By how expensive an investment is, I don't mean how high its price is. A stock can be priced at $1,000 and be inexpensive and a stock can also be $10 and be super expensive. Let me explain.

If I offered you a new Ferrari for $25,000, $25,000 might be a high price, but you would recognize that given how amazing of a car a Ferrari is, its value is way higher. Similarly, if I offered you a pen for $100, although $100 might be a nominal amount to you, you would say that the pen is overpriced and you'd be right. How does this analogy relate to stocks and the underlying companies? Join me in the next post as we explore how a company's valuation determines whether you should invest.

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