Investing in Real Estate: How Does It Compare to Stock Investing?

For those of us who are on Canada, the value of our condos and houses was left luckily unscathed after the Great Recession.  In fact, the prices took a breather during those dark days and continued its upward trajectory shortly thereafter.  As an example, the value of the townhouse we bought back in 2006 gained about 30% in value by 2011.

If we factor in the leveraging effects of owning a mortgage, my return of investment would have been about 100% in 5 years.  That's about 15% per year, not a bad investment at all!  Naturally, the question that gets frequently asked is whether investing in real estate or in stocks is more profitable.  Obviously, circumstances play a big role, but in general, which gives better returns?

Was the Last Decade a Particularly Good Decade for Real Estate in Canada?
Most of us have very good short term memory.  In fact, we tend to extrapolate scenarios to predict future events.  Tell me that you've never looked at a stock chart and extrapolated the line to see where the price would be 6 or 12 months in the future!

Here at The Catholic Investor, we look for hard and fast data to back up our claims.  I'll use a website that I frequently visit to obtain this data.  It's the Toronto Real Estate Board website at http://www.torontorealestateboard.com/.  They publish, on a monthly basis, a summary of the transactions made in the prior month.  They also show the average price of homes in the Toronto Area for the past 45 years on a yearly basis.

If we look at the long term trend of the Toronto house prices (i.e. from 1966 until 2011), the average home price has grown from $21,360 to $465,412.  This translates into an annual growth of 7.1%.  Although it feels like the last 15 years have been exceptional in terms of real estate price appreciation, the fact is the average annual growth was only 5.9% per year during this period.  Looking at Figure 1, where housing prices are plotted on a log scale, we can readily see that the past 15 years have actually been pretty average.  On the other hand, housing prices went through the roof in the late 1980s and quickly came back down in the early 1990s.

Figure 1: Average GTA Housing Prices Over the Last 45 Years

So, the conclusion I will draw is that the last one and a half decade had been pretty average in terms of housing price appreciation.  Perhaps it was because of the downturn in the early 1990s that made the last decade seem like it was too good to be true.  That's just not the case.  In some major US cities, housing prices doubled between 2003 and 2006, during the peak of the housing bubble.  That translates to approximately 20% growth per year.  We were nowhere near those numbers in Toronto.

Free Money?
There is a common strategy in real estate investing that can increase your growth and that is rental income.  If you are one of the few people who can afford to buy a second piece of property and rent it out, it seems like it's a no brainer.

In Toronto, a typical 1-bedroom condo apartment typically costs around $250-350K, depending on location, amenities, etc.  That same condo unit can fetch around $1000-1500 per month in rent. After deducting property taxes, maintenance fees, one has about $600-900 left per month, which would be enough to cover the payment of a mortgage if one had put 25% down payment and a 25 to 30 year amortization in a mortgage.  It's essentially free money, as they say!  The unit is self sufficient and as it grows in value, so does one's net worth.  One assumption, and a big one at that, is that mortgage rates would remain relatively low.  If mortgage rates were to rise, one may have to put money into the investment as rent would not be able to cover the expenses.

So, what do the numbers looks like if we were to buy a condo unit and rent it out today?  Let's say we buy a 2-bedroom unit for $400K and we rent it out for $1500.  I'm a little conservative on the rent, but let's see what we get.  Assumptions made are also shown below.  The one thing that I want to point out is that I have not factored in inflation into the mortgage payments.  Since the mortgage payments are locked in and do not rise, they effectively get cheaper and cheaper in the future as prices of everything else rises.  As for the monthly rent and taxes/fees, they would likely rise with inflation.  So, the present value of these would be whatever they are currently.  If I've lost you on this...not to worry, in the end, the annual growth would only deviate by a percentage point or so.

I've used 4 different scenarios.  The first is an optimistic one where variable mortgage rates would remain at around today's rates for the next 10 years.  The second is a very realistic scenario where one can get a 10-year fixed mortgage at 3.8% (this is available today and is likely a smart move if you were to lock in today for 10 years).  The third is a pessimistic scenario where the average mortgage rate is seen to be at 6.5%.  The last is if we had purchased the property outright from the start.  The average return per year are 13.5%, 11.7%, 8.2%, and 9.6%, respectively.  Not bad at all!  In fact, it's a pretty good investment, especially since I had used a quite conservative rental income.




What's the Catch?
From the scenarios above, it does seem like investing in real estate is free money.  As we know, there's no free lunch in this world, what's the catch?  There are a number of disadvantages with real estate investing that  do not exist with investing in stocks or funds.  They include finding renters and collecting rent, work in maintaining the property, using the "room" that you could have used in buying a bigger house for yourself, etc.  However, the biggest catch is quite apparent, especially to home owners across the border, in the United States.  They would quickly tell you that the housing bust of 2008 wiped out a huge portion of their net worth.

By owning a mortgage, one is essentially leveraging up on the investment.  By taking advantage of the low mortgage rates (Scenario 1 and 2), we were able to increase our returns.  But as we can see in Scenario 3, if the rates rise, it actually hurts us to borrow.  In any case, because we are likely not able to buy a property outright from the start, we would have to leverage up.  It's great when the market goes up, but if we see a repeat of the US housing market in 2008 here in Canada, it would be disastrous.  Let's say the market goes down 20%...doesn't sound too bad, right?  Wrong.  In our case, 20% of $400K is $80K.  We put down $100K initially.  So, if we were to sell the house right there and then, we would have banked a -80% return!  Yikes!

In fact, this is the main reason there are so many foreclosures in the US.  It's not that people could not afford the mortgage payments, it's because the house value has dropped so much that it makes no sense to keep paying the payments because the home owners are so deep in the red.  So, the biggest risk in real estate investing is a housing market downturn.

So Which Is Better?  Real Estate or Stocks?
It is true that the real estate market is less volatile than the stock market, but it is also important to remember that volatility does not equate to risk.  While some may argue that real estate investing is safer, a much longer debate is required for that topic.  Here's the summary for real estate investing: 1) it takes more work (renting out, etc.), 2) there is less volatility, 3) if you own a mortgage, in the less likely event of a market downturn, your losses are amplified.

As for stocks, since most people do not buy on margin or trade options exclusively, the leveraging effects are not as large.  Individual stocks and even the market in general are more volatile than the real estate market.  However, if you know what you are doing, you may be able to capitalize on this volatility.

In the end, it's about your comfort level.  Most people feel safer with real estate, because of its tangibility and the notion that people always need to live somewhere.  Fair enough.  However, if you look at the richest people on the planet, a large majority got there by owning awesome businesses, and only a handful got there through real estate.  I believe that speaks volumes.  As such, I'm still a stocks kinda guy!

Don't Be Afraid of Options - Part 5: Let's Get Naked (with Options)!

Please excuse the title of this post...I had to! :)


We have learned about buying call options and put options, and also writing a covered call option.  Let's continue with writing an uncovered or "naked" option in this post.  Why is it called "naked"?  This term has been coined because the seller of a naked option is left exposed to unlimited risk (in the case of a naked call).  Recall that when you buy a call option, the most you can lose is the amount of money you have spent buying that call option.  Also recall when you sell a covered call, when the underlying stock price rises above the strike price, all you have to do is hand over the shares that you already own of the underlying stock, and you're done.  Not so with naked options.


Naked Calls
For a naked call option, what you do is exactly the same as a selling a covered call, except you don't own any underlying shares.  Let's use an example to illustrate this.  You think Ford (Ticker: F) at $11.71 is priced too high and predict that it would fall by January 2011.  So, you sell a call option with a strike price at $12, set to expire in January 2011.  You get paid a premium of $1.10/share, which is what this option is trading at currently.  If the stock stays below $12, the option expires worthless and you get to keep the $1.10/share premium.


However, if your prediction was wrong and the stock rises to $14, the buyer of the option exercises his right to buy 100 shares at $12.  Who would sell him those shares?  YOU!  Since you sold him the right to buy 100 shares at $12, you have the liability of fulfilling that contract.  And since you don't actually own any shares of Ford, you need to buy 100 shares in the open market at $14/share and give them to the owner of the call option for $12/share.  So, you earned $1.10/share in premiums, but lost $2.00/share because the buyer exercised the option ($14/share you paid - $12/share the option owner paid you).  You netted -$0.90/share.


This is if you were lucky!  If Ford had skyrocketed to $22, you would need to pay $22/share in the open market and sell them to the option owner for $12/share.  You stand to lose $8.90/share ([$22 - $12] - $1.10 premiums).  The higher the stock goes, the higher your losses.  That is why your losses are considered unlimited.  As long as the stock goes up, your losses go up.  Therefore, I absolutely do not recommend writing a naked call.  By exposing yourself to unlimited risk, you stand to gain only a fraction of what you could lose.  This is the wrong side of the bet!


Naked Puts
Naked put options, although appearing similar to naked calls, are a completely different beast.  For one thing, your losses are not unlimited.  Say you sold a put option of Ford with a strike price of $11 and expiry date of January 2011 for $0.89/share.  You essentially have sold the right to sell shares of Ford for $11 at anytime before the expiry of the option to the buyer.  This is a bullish position.  If shares remain higher than $11, then the buyer would not want to exercise the option, because he can sell it for more on the open market.  However, if Ford tanks and goes to $10, the buyer can exercise that option, and you would have to buy the shares at $11.  If Ford totally went bankrupt and the shares went down to $0, you would still need to pay $11 for those same shares.  That's too bad...but that's the worst it can get.  The share price cannot go into negative territory.  Your maximum loss is simply the strike price of the option minus any premiums that you had received when you sold the option.


When Should I Write a Naked Put?
As I said, writing a naked put option is a bullish position.  It is especially useful when you are trying to accumulate a certain stock.  By writing a put option, you can potentially increase your returns and lower your risk (wait a minute, aren't those two polar opposites?  Keep reading...).  Let's use an example...I like examples, they make things easier to understand.


So, real life example...if you have followed my trading history, you would know that I've been accumulating True Religion stock.  I began buying when it was $29.31.  In merely 5 months, the stock has shed more than 35% of its value.  It's trading at $18.75 today.  This is one volatile stock!  No worries, I kept buying as it came down.  Lately, I've been thinking about writing naked puts (thinking only, because I need to "upgrade" my account, more on that below).  I checked out the prices of TRLG's put options and were quite surprised at how much people were willing to pay.  I looked at one with a strike price of $16 and expiry in April 2011, and people were asking for $1.95/share.  That's more than 10% of the stock price!

So, if I can successfully upgrade my account, and sell that same put option, I would immediately get $1.95/share for it.  If the stock goes down to $16 and the option is exercised, I simply buy 100 shares per each contract that I have sold.  Is that bad news?  No, not at all.  If I had not sold the option, I would still have bought the shares.  So, why not make $1.95/share while I'm at it?

In fact, by writing a naked put, I have lowered my overall risk.  Compare this...if I were to only buy the shares when TRLG dropped to $16, and the stock fell some more to $15, I would have lost $1.00/share. However, if I had sold that option, I would have been paid $1.95/share for it, and as a result, I'm still up $0.95 (the shares costed me $16/share - $1.95/share of premiums = $14.05/share)!  Now, that's having your cake and eating it too!  So, please, don't listen to the industry's seemingly intuitive and believable lies, "if you want greater returns, you have to take greater risks."  Selling naked puts when you are trying to accumulate a stock is what I call prudent investing!

The Catch
Yes, yes, there is a catch.  Not a big one though.  In order to be able to write naked calls or puts, you need to have a margin account, because after your initial transaction, you can still rack up additional losses.  Depending on your broker, they would likely limit how much risk you are exposed to.  So, chances are, they probably would not let you write too many risky naked options if you did not have the cash to back them up. You may either need cash sitting around in your account or the appropriate collateral (i.e. you may be required to sell your holdings) if the trade goes against you.

What Now?
I don't know about you, but I'm going to get my account upgraded!  When I talk with friends and such, most tend to think of options and margin accounts as very risky things, without really knowing what they are all about. It's sort of like a gun.  If a gun falls into the hands of an irresponsible person, it can be very dangerous and no one should allow that to happen.  However, if on the other hand, the person in question is a trained police officer with years of experience, we would feel much safer if he had a gun in his possession, compared to if he had not.  And so, that is the case with options.  Learn to use the tool and don't be afraid of it.

I've almost exhausted all of the things I can talk about options, without going into really fancy stuff, but wait, the best is yet to come.  I will give you a tool that can enable you to evaluate various option strategies, even those I have not talked about.  Stay tuned!

Don't Be Afraid of Options - Part 4: Buying Puts as (Expensive) Insurance

Let's face it...nobody likes accidents, not car accidents nor accidents in his/her investments.  For the former, we all have liability insurance to protect us against lawsuits and comprehensive insurance to protect us against losses due to accidents or theft.  For stocks, there is a way of buying insurance and that's by buying put options for that the same stock of which you hold shares.

As you recall, by buying a put option, you have the right to sell a certain stock at a certain price before a certain date.  So, if your stock dips below the strike price of your put option, the option becomes in-the-money and you can exercise your option.  By doing so, you can sell your shares at the higher strike price, thus, limiting your loss.  This all sounds good until you find out what the premiums are for this insurance.

Hefty Insurance Premiums
For my car (I just bought a 2006 Toyota Prius for $14650 CAD), I'm paying about $120/month of insurance.  A majority of that cost is in liability insurance.  A small portion is for comprehensive (the portion that actually covers my car).  I don't know the exact breakdown, but I believe it's something like 80-20 split.  So, effectively, I'm paying about $300/year to insurance against the cost of my car.  That is about 2.0% of the cost of my car for 1-year's worth of insurance.

Now, let's look at the cost of buying a put option to insure against your investment.  Um...let's look at Apple today (Ticker: AAPL).  The price of AAPL shares are $262.55 at the time of writing.  Let's say you had 100 shares of AAPL and were really worried about that iPhone 4 antenna.  So, you decide to buy 1 contract of a put option at strike price of $260 that expires in August 2010.  That will set you back a cool $6.00/share as it is currently priced.  Notice that this option is out-of-money because the strike price is $2.55 below the current share price.  If the stock falls below $260 before the 3rd Friday of August, you can exercise the option and be able to sell your shares for $260.  But how much is the premium that you are paying?  That's easy enough to calculate...$6.00 (price of option) divided by $262.55 share price = 2.3%.  So, you are paying a premium of 2.3% per month to insure your investment!

Things get a little better if you opt for the longer term.  If you decide to buy the same option that expires in January 2012, the price is $46.69/share.  That works out to be $2.60/month or 1.0%/month.  It all sounds good except when you really look at the implications.  Since you paid $46.69/share for that put option, you are down $46.69/share right away...poof...gone!  Before anything even happens, you're down 17.7%!  In fact, for you to break even, AAPL needs to rise to about $309.

So, why would anyone buy a put option for insurance purposes?  Actually...yeah, why?  If I wanted to hold AAPL until August, what I could do is simply this: buy AAPL at $262.55.  If it drops by $8.55 ($6.00 cost of option + $2.55 since the strike price is at $260), which is exactly how much it would have cost me to buy a put option with strike price of $260, I would sell the shares and say, "OK, that's enough for me."  That would have the same effect as buying the put option.  If instead of dropping, it rose in price, I don't have that $6 premium weighing down on me; I start making money the moment it rises above $262.55.  One caveat is that if the price drops a huge amount overnight (i.e. more than $8.55), then your loss would be greater because the next morning, you would have to sell at the lower share price.

Conclusion

In theory, buying a put option as an insurance policy is a very prudent move.  However, in reality, put options cost so much that they outweigh any benefits that they provide.  I do not recommend using this strategy unless for some reason, the put option is priced very cheaply.  Plus, if you have done your homework and know exactly how much your stock is worth, then when the price goes down, you would actually want to buy more to accumulate the stock!  That, however, is the topic of another post!  For you Canadians, have a good long weekend!

Rule #1 Analysis Spreadsheet for Free!

Free lunch!

You know what they say, "There's no free lunch in this world!"  Hey, I'm telling you now, there is!  If you've been reading my blog, you know that I'm a big fan of Phil Town and his book, Rule #1.  In it, he gives the reader a very methodical way of finding the intrinsic value, or its "sticker price", of a stock.  He looks at the "Big 5s", 5 numbers that tell you how well a company is doing.  They are: i) return on invested capital (ROIC), ii) sales growth, iii) earnings per share growth, iv) book value per share growth, and v) free cash flow growth.  He wants all 5 of these numbers to be greater than or equal to 10% on average for the last 10 years.

For those of us who are not accountants, not only do we not know where to find this data, we don't even know what half of these things mean!  Well, there are 2 steps to rectify this situation: read his book (link on the right), and use my spreadsheet!  I can't provide the first for free, but your local library may be able to.  I can, however, offer you my spreadsheet for free (if you feel obligated to repay me, just email your friends about how great this blog is!).  You can download it right here.  There is a macro embedded in the spreadsheet.  Don't worry, it's not a virus...I just wrote some code to simplify the process.

There is a short tutorial inside the spreadsheet itself.  So, I will not go into the details of the mechanics here.  Essentially, you type in the symbol of the stock of interest, click a few links, copy and paste a few tables, press a couple of buttons, and you have on your monitor, a Rule #1 analysis done for you, all in 2 minutes.  If you are having trouble with it, just leave me a comment.  I'll be sure to respond.

You guys can all thank Anthony for leaving a comment on my previous post on how to read the Form 10-K of True Religion.  He reminded me that I should share this spreadsheet with the rest of the world.  Anyway, give it a try.  I've saved countless hours with it.  On my next post, I'll talk about the results I got for True Religion with this spreadsheet.  Stay tuned!

Update February 17, 2011: I've updated the sheet.  Go to the Investing Resources to download the latest sheet.

Why Catholic Investors Should Use Fundamental Analysis - Part II of II

It's Not a Game of Chance!

This is the second half of my intro to Fundamental Analysis. When you buy a stock, you do not need to hope and pray once that buy order has been filled. It is NOT like when you play roulette and the ball has been spun. This is because you know you have bought a stock that will likely go up! I will talk about a few tools that will help you identify whether a company is undervalued or not.

Price-to-Sales Ratio

Ken Fisher pioneered the use of the Price-to-Sales ratio (P/S ratio) in the 1980s. One of the disadvantages about using the P/E (profit-to-earnings) ratio is that it doesn't really work if the company is not making any profit! Sometimes, you may find a company with very good prospects but is not currently making any money. How do you judge if this company is worth buying? The price-to-sales (P/S ratio) can help you.

The concept behind this ratio is simple. A company has a certain amount of sales or revenue and also costs associated with running the company, etc. For a good company, a portion of that sales will become profits. For really good companies, that percentage can be as high as 50% or 60%. What that means is for every dollar that its customers pay, 50% of that money is pure profit.

This helps us very much. Let's say a company has sales of $10 per share. The price of the stock is $15. It's not making any profit currently, but what if it starts cutting costs and starts making money at 50% margin? That means that it has $5 earnings per share ($10 sales × 50%). The P/E ratio becomes 3 ($15 divided by $5). And we know that for a healthy company, a P/E ratio of 3 is a dream come true for us investors! So, we definitely want to by this company!

So, what was the P/S ratio for that company we just talked about? It was $15 / $10, or 1.5. Of course, an operating margin of 50% is not easy to achieve. You will need to do some research on the particular industry you're looking at. If the profit margins for most of the companies in that industry is 20-30%, you may want to use 20% for your analysis.

Some people recommend that a P/S ratio of 1.0.  I would definitely not go blindly and start buying any stocks that have a P/S ratio of less than 1.0.  The company may be in huge debt and could go bankrupt at any moment!  So, please do your homework!

Price-to-Book Ratio

A ratio that has been used for many, many years is the price-to-book ratio. It is a very well known ratio in value investing circles. The theory is very simple as well. A company owns many assets such as buildings, machinery, computers, product, etc. If it were to be liquidated, all of these assets can be sold for a value. This is the "book value". Sometimes, a stock may be traded at value that is lower than the book value. It's almost like someone coming up to you to sell you a $1 bill for $0.50! It's a little irrational, but it does happen!

So, a P/B ratio of less than 1 will start to get us excited. A caveat is that the book value may be inflated. It is a matter of accounting and goes beyond my knowledge. My advice is the same as always: be prudent and dig a little deeper. What seems too good to be true may be just that!

Get Out of Debt!

A company may have great P/E and P/S numbers, but it may also have a huge amount of debt. You have to wary of these companies. As we all know, with debt also comes interests. Debt is not necessarily bad in itself. Most companies borrow money so it is able to expand or to carry inventory, etc. However, if debt is too high, then you may want to avoid buying the stock of that particular company. You want the debt to be small enough that the company can pay back the debt in a few years. Simply compare the amount of debt to the earnings or free cash flow of the company. That will give you an idea of whether a good deal is really that good!

It's All So Complicated

You know what? You are right! Fundamental analysis is not easy and is still very much an art than a science. Most books will tell you exactly what I have told you...a whole bunch of ratios and no real way to evaluate if the business is fundamentally sound. Also, they will not give you a real quantitative way of determining under what price we should buy a company.

There's no need to fret! Take a look at one of my older posts: Rule #1 - The Book That Energized Me. It talks about a book that gives a very, very simple and quantitative way of determining whether a company is undervalued or not. I will likely write another post that is more in depth to discuss the actual calculations that the author, Phil Town, teaches. Stay tuned!

Why Catholic Investors Should Use Fundamental Analysis - Part I of II

Fresco at the Vatican, by Michelangelo, depicting the personifications of Fortitude, Prudence, and Temperance

The Virtues

In Catholic teaching, there are 2 major categories of virtues: human virtues and theological virtues. Theological virtues (i.e. faith, hope, and charity) are the basis of all other virtues and they relate to God. The human virtues, virtues that help us do good, are divided into 4 Cardinal Virtues: prudence, justice, fortitude, and temperance. Today, we will look specifically at the virtue of prudence.

Prudence, as defined by the Catechism of the Catholic Church (CCC 1806), "is the virtue that disposes practical reason to discern our true good in every circumstance and to choose the right means of achieving it...it guides the other virtues by setting rule and measure." Simply speaking, prudence helps us choose good and how to attain it with care. It is a virtue that proves to be invaluable to every investor.

Reckless Investing

When not using prudence in investing, it becomes what I call, "reckless investing". I have done some of that myself. It was the year 2000...I was 22 years old and had a beautiful image of the world (I still do, but in a different way). I have heard about people buying and holding stocks and making a small fortune over time.

I was hired as an engineering intern at Celestica, Inc. (Ticker: CLS). The dot-com days were coming to an end, but I had no idea. It seemed like everyone was doing very well in their stocks, because as we all knew, the internet will revolutionize the way we do everything! And the high-tech companies that were involved with manufacturing the infrastructure were bound to benefit. So, I bought into this thinking and invested my savings into the likes of Celestica, Nortel (ticket:NT...but they're in bankruptcy protection now, so you won't find much), AMD (ticker: AMD) and Nvidia (ticker: NVDA).

At that time, I had no idea what fundamental analysis was. Heck, I didn't even know what technical analysis was. I simply just bought stocks that had names attached to "tech". The most that I did was look at the stock's chart and extrapolated into the future to see how much money I would make. What happened after that, you are all fully aware. I made a couple of thousand of dollars at first, but soon saw much of my investment vaporize into thin air. This is the perfect example of "reckless investing".

Why was it reckless? Let me illustrate with an analogy. One sunny Sunday afternoon, you walk into a flea market. You want to buy something, but you don't know what. Soon, you see a crowd gathering around a booth, swarming to buy a gadget you have never seen before. You have no idea what the gadget does, but it does look kind of fancy with some spinning fins and a long cord. Most of the people around you don't know what it was either, but they all know it was a good buy since everyone else was buying it. So, you whip out a fresh $20 bill and hand it to the seller. As you walk home with the gadget, you admire at how shiny it is. Once you get home, you show it to your wife. She takes a look and says, "Hey, that's the USB fan they were selling on TV for $3.99 including shipping!"

That story sounds a little unbelievable, but that is exactly what investors were doing in the late 90s and early 2000s. They bought into companies, which they had not a clue what they were about, but most of all, they had no idea what they were worth. This is a result of lack of prudence on the part of investors. To be prudent is to know what a stock is worth and buy at a price below that.

Fundamental Analysis

Fundamental Analysis attempts to find the value of each stock. It's like buying bread at the supermarket. Even if everyone was buying a loaf of bread at $200 per loaf, you wouldn't pay $200 (unless there was a widespread famine), because you know a loaf of bread is only worth $3. Therefore, fundamental analysis seeks to find the intrinsic value of a stock.

Before we begin, let's look at a misconception of how stocks work. Stocks are traded in a stock exchange (e.g. New York Stock Exchange), where you, me, Warren Buffet, or the bum down the street may have access to (as long as we each have an account with a broker). The price of a stock at any given moment is simply the last price at which it was bought/sold. There is absolutely NO fixed relationship between a company's assets, earnings, or future prospects with how much a share of its stock is sold for. It is entirely determined by the price people are willing to buy/sell the stock for. However, having said that, people who buy/sell stocks are somewhat rational (at least most of the time), and will look at the company's well-being to determine what price is right.

There are instances where euphoria or depression hits the entire stock market. You can find evidence of the former in the late 90s where companies were bid up to prices hundreds of times above their earnings. The latter occurs in more recent memory in March of 2009, when the S&P 500 hit 666 points, more than 55% off its peak. The stocks were either traded at prices way above or way below what they were worth. So, our quest is to find out what the stocks are worth, buy at prices way lower than their worth, and sell at prices way higher.

Some Basics

Instead of looking at public companies, let's look at a small business to simplify things. Say your brother-in-law comes to you one day and proposes a business deal. He wants you to chip in to buy a local coffee shop. "Hmm," you think to yourself, "How do I know I'm not buying a sinking ship?" You then ask him to show you some numbers.

The current owner is asking for $500K for the coffee shop. For the past 5 years, business has grown from making profits of $40K/year to $75K/year. You have to admit, as well, that their coffee is pretty darn good. Ok, you say to yourself, if we invest $500K to buy this coffee shop, how long is the payback period? Assuming the profits continue to hover around $75K/year, it would take you a bit more than 6 years to recoup your initial investment. After that, it's all free money! You decide that it's a good deal and go ahead with your brother-in-law's proposition.

What we just looked at is the Price-to-Earnings ratio or P/E ratio as it is more commonly known. We essentially divide the price of a company by the profits it makes in the last year. How does that work for a stock? It's pretty much the same. When you research into a stock, you will readily find the earnings per share (EPS) published. That number is calculated simply by dividing the money the company makes in the last 12 months by the number of outstanding shares. You can then calculate the P/E ratio by simply dividing the share price by the EPS.

So you now know what the P/E ratio is, but how do you use it? It's simple. If the P/E ratio of a company is 1, it means in one year, the company made the same amount of money as it is currently valued. It is an excellent deal for a stable company, because you know the money will keep rolling in and you will have recouped your money in one year. There's very little risk in this investment.

If you find a company with a P/E ratio of 100, it would take 100 years for you to recoup your initial investment if earnings were to be kept consistent. That would not be a good deal!

The S&P 500 have averaged a P/E of between 12-18 in the past 50 years. For a company with steady earnings, you can expect the P/E to be around 10. For a growth company, the P/E can be 15 - 40. Many companies in the dot-com days had P/Es of greater than 100! As you can see, its not an exaggeration when I call my investing, reckless investing!

To Be Continued...

The P/E ratio only paints a small part of a bigger picture. If you find a company with a P/E of less than 5, it doesn't necessarily mean you have found a gem. The company may be in decline and its competition is about to wipe it out. Conversely, if you find a company with a P/E of greater than 100, it does not necessarily mean that it is overvalued. It may have been losing money in previous quarters, but the business is turning around. Earnings barely broke even, and therefore, the P/E ratio is inflated. Or, maybe the company is in growth mode and its earnings are on a straight trajectory to the moon. We need to look at many other factors to determine the value of a company.

In the second part of this post, I will go into more depth the different tools an investor can use to estimate a company's value.