What IS the Right Price?

Have you ever followed a housewife to the wet-market where she does her grocery shopping (or what we in Singapore call “marketing”)? I used to accompany my mother when I was much younger, and while at that time, it didn’t seem like much to me, the wet-market really isn’t that different from the financial markets. The housewife would pick over the produce, prod the fishes to test its freshness, and then if she likes what she is prodding, she might bargain with the seller, to obtain what she thinks is a good price. If she isn’t sure what the price should be, she moves on to the next store, selling almost or entirely the same thing, and checks out the price there. 

This behaviour isn’t restricted to the prudent housewife buying seafood. When I for example, want to buy a TV, I go into a shop, and look at all the different models on offer. Shopping helps me identify what it is I am looking for, say the dimensions of the screen, the type of technology like 3D or LCD or plasma, and then also consider the brand and its reputation. And, of course the prices. After narrowing it down, based on my criteria and budget, I might settle on a particular model. I might then go to a different TV retailer to see what he is selling that model at and finally, at the cheapest shop, I might still try to negotiate a better price. Or I might have to just walk off empty handed since nothing fitted either my criteria or my budget.

Most people do have quite clear rationales when shopping for things. Ask a teenager how he chooses his smartphone and he might regale you with its features. Or an executive how he chooses his car, and he might run down a list of specifications like the size of the engine and the fantastic electronics and the design and repute of the marquee.

Should one buy stocks of companies with any less rigour? What exactly is it about stocks that can cause some people to buy it on a whim or less than sufficient understanding? Does investing for the future require any less effort compared with a TV set or a car? AND, is it that different?

One reason why people tend to find it hard to analyse investments is because it tends to be something more abstract. You can see and touch and feel a physical car, or vegetables, but with a stock, this might be a little harder to visualise. But remember this, what you are buying, when you buy a stock, is a stake in a real company with real products and services, who have real people working in them, and real managers. Sure, you might not have access to the CEO to personally question him about his management methods or style, BUT you do have access to the products of that firm. Say you want to buy a stake in Coca-cola (only the most recognisable brand in the world!). You can get a can of it, drink it, slurp it, and consider why this soft drink is so unique that it entices millions worldwide to enjoy it daily. Or say  McDonalds. You can go into its fast-food outlet and look at how they have set themselves up, with its uncomfortable chairs, loud and fast music, and its burgers, with its questionable nutritional value, and wonder what exactly makes this one of the most successful franchises of all time.

But yet, one thing to keep in mind is, a great company might not be a great stock. Everything has a correct value, a correct price to pay. A lousy company might be a great investment at the right price, and a fantastic company might prove to be a poor investment if its already overpriced. Just like how you would walk away from buying that car if it exceeds your budget, what is that price to pay for that company’s stock?

Relative Valuation

Shopping around for a price and comparing between different models is something we do for investments also.

Say you are interested to buy a company’s stock. You also can compare with other companies’ in the same industry, and even compare that company with all the other companies that are available for sale in the stock market.

Various metrics are available to facilitate such a comparison. Price/Earnings or P/E is one of the most common indicators that are used, which essentially is, how much should a dollar of earnings cost? Earnings are the profits of a company, the earnings in P/E refers to the earnings per share, since a typical company typically has millions of shares all of which represent tiny stakes in the firm. Price/Book is another common metric, which compares the current price of the stock to the value of the net assets of the firm.

These metrics can be calculated and compared for different companies, and it can reveal whether company Alpha is valued cheaper relative to company Bravo. Say Alpha has a lower P/E than Bravo’s, which means its price is cheaper for each dollar of its earnings. That means Alpha’s earnings are not worth as much as Bravo’s currently. It might seem peculiar that 2 companies that are similar (operating in the same industry, producing similar products, competing for the same group of customers, and having equal quality), can have their earnings priced differently. I can hear you asking already, so why is that so?

Precisely, the differences warrant further investigation. Bravo might have a brighter future, or is simply producing a cooler product (think Apple vs HP), OR Bravo might be plain overpriced! Or it could be that Alpha is really tottering on the brink of bankruptcy given its bad management of its funds, and hence has its price completely shot down. OR it could be revealing an excellent opportunity to buy into Alpha. The relative valuation of the various companies can be a great start point to begin analysing the companies further.

But say, there is this new product in that electronics shop today, let’s call it the BaDaBoom, which is suppose to do a heck of a job walking your dog. No one has seen such a product before, and everyone (with a dog) wants one.

Since there is no other comparable product, relative valuation seems to have reached its logical limit. How does one know what IS the right price to pay for a BaDaBoom?

Absolute Valuation

And that’s when absolute valuation techniques come in handy. Here’s a teaser to help you think about the issue, till my next post:

A completely trustworthy and honest man tells you, I have this wonderful machine, which would pay you $10 a year, every year, forever, but it is not free. How much would you pay for this machine? What IS the correct price for this machine?

Disclosure: I still go with my mother shopping occasionally, and I do own a couple of TVs. I however do not currently own McDonalds, HP, Apple or Coca-cola, though at some point in the past, I have had holdings in all 4 firms. Alpha and Bravo are hypothetical companies. And BaDaBoom does not exist, even though it might in the next 10 years or so.