Value Investing Principle #4

Today I’m going to talk about Value Investing Principle #4.

This is the last principle for Value Investing and one I was so very curious to learn about. If you’ve missed the first three principles, you can read more about them in my previous blog post - Principle #1, Principle #2 and Principle #3.

Principles #4 is about “knowing the value of the business and then buying it at a much lower price.”

This means you need to understand how much the business is worth and then wait patiently until it goes on sale. Perfect, but how do I do that?

You hear about stock prices going up and going down. It’s splashed on social media, on newspapers and on tv. When the stock market gets “exciting” the buzz of chatter and opinions around you seems endless. So to a person who knows nothing about what price to pay for a stock (insert me), all this talk seems scary and overwhelming so I just tune it out.

Until now. 

Enter principle #4. Working through this step will help you understand what a reasonable price is for a stock and then knowing the sale price at which you want to buy it at.
Uhm, sale price? Yes, you do not want to pay just any old price for a stock. In fact, you don’t want to even pay a reasonable price. You want to pay a discounted price. Exactly the same approach I have with many other purchases in my life.

Knowing the Value of a Business

I’m going to say something a bit controversial so here goes - the price of a stock is not its value. You can google that statement and find that many wise people will tell you otherwise. If the price of a stock is its value, then a valuable company would never go on sale… yet they do. And they do for a variety of different reasons which we’ll explore in later posts.

So why does the value of a business even matter? When a business has great value, it means it’s likely providing a great service. When a company is providing a great service, its financial numbers will reflect this from years past. If you were to buy a stock of that business, you would want to be able to continue making money from this company for years to come. 

With Value Investing, there’s 3 methods to evaluate the price/value a stock: Ten Cap Price (which is based on owner earnings), Payback Time Price (which is based on free cash flow) and then Margin of Safety Valuation (which is based on earnings). Check out the book  written by the host of the “InvestED” podcast, Danielle Town, called “Invested - How Warren Buffet and Charlie Munger Taught Me to Master My Mind, My Emotions, & My Money.” She breaks down these 3 methods in easily consumed ways.

Ten Cap Price is a pricing method which is based on the business owners earnings. Payback Time is a pricing method which is based on the businesses free cash flow. Margin of Safety is a valuation method which is based on the businesses overall earnings. 

With these pricing and valuation methods, you imagine that you’re buying the whole business. When you understand a businesses price as a whole, it’s a lot easier to then understand how much you would want to pay for one stock of that business

Buying the Business On Sale

You don’t want to pay just any old price for a stock. In fact, you want to pay a much lower price than most people will pay for that exact same stock. Why you ask? Because when you buy a stock on sale, your return on that investment is much greater (aka. you make more money). 

This sounds like a wonderful idea but is it achievable? Yes it is.

Once you know the price and value of a business you will understand what a reasonable price is to buy 1 stock of that business, then you wait until the price of a stock is lower than that. This requires extreme patience. 

The 3 pricing and valuation methods above provide a buffer so you’re protected from most mistakes. Meaning, you have a cushion in case your research about the business missed some critical pieces. This also alleviates the overload of information society provides about the stock market because when you’ve completed your research and calculations you can sit confidently in the results you found and let the speculation sound like Charlie Brown’s teacher… “wah, wah, woh, wah, wah”. 

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