Before everything else, let me just inform you that there are two other lessons before this. If you are just joining us now, I suggest you go back to lesson 2 and 3 first.
To recap, we were talking about an ice cream stand owner named Nancy and how she values her business. In this lesson, we are going to use Nancy and her ice cream stand to teach concepts of breaking a company down in shares.
In the previous lessons, Nancy was having a hard time selling her business for $200,000. Now, she decided to lower the price to $100,000. However, she still encounters a lot of problems doing it. Another option is to break the company down into shares.
What is the share of stock? Nancy values the ice cream stand at $100,000 and she was trying to sell with no luck. Now, she divided this company into $10,000 pieces. The little squares on the video represent that she split the business up into $10,000 different pieces, and one piece of that business equals $10. Therefore, if you take $100,000 to buy $10,000, that’s $10 per share. The take away term here is “Shares Outstanding”. It is the correct terminology when buying stocks.
The number of Shares Outstanding is the number of pieces the company has been divided into. Steve Jobs’ Apple probably has close to a billion shares outstanding. That’s how many pieces Apple is broken up into. If you own one share, you own 2 billionth of the company.
Let’s compare the terminology between a whole business and one share. The terminology “market price” is what Nancy’s asking for the business – she wants $100,000 for her business. The income statement, the balance sheet, and the cash flow statement are the three documents that a business has to represent its value. If you read those documents, you can understand its worth. On the income statement’s bottom line is the net income. For Nancy’s business, her net income was $20,000 and that represents her profit. In one year, she has made $20,000. The balance sheet represents the equity. If Nancy would end her business today, fire her employee, sell everything, and pay off all her debts, what would be left is $7,000. $7,000 is the equity, meaning the margin of safety is the difference between the equity and the market price. Let’s assume that you want to purchase this business for $100,000, but since it isn’t making any money, you want to shut it down. You will receive $7000, so your margin of safety there is very little. If the business continues to run and thrive, you can expect to make $20,000 in a year.
When we look at the whole business, the numbers suddenly make sense. Again, the cash flow statement will be taught at a later period. Take a look at how the terminology changes as we look at one share. Here we are and you can see that we have one share. The total number of Shares outstanding is $10,000, so we know our market price is $10 a share. We just took $100,000 to buy $10,000.
The best way to really understand stock investing is to look at one share like it’s a miniature business. This might sound crazy, but think of little miniature people working in that little miniature ice cream stand. Instead of it producing $100,000, it’s only worth $10 because it’s really small and tiny. That might be a silly way to look at it, but for some people it makes sense. Let’s assume that the market price on this little small business is $10 a share. If you take the $20,000 from that income and you divide it by the $10,000 Shares Outstanding, you’d be left with $2. The EPS stands for earnings per share. So for one share, the earnings are $2.
For the balance sheet, on a whole business it was $7,000 for the equity. When you look at a per share basis, it isn’t equity anymore, but is called the book value. . I don’t know why they changed the terminology, but it’s probably because it makes it easier to understand. For example, when a person says, “Well, the book value is $2.”, you know that you’re talking per share, but what you need to know is it doesn’t matter if you are talking about the whole business or one share. It’s all proportional because everything is being divided by the Shares Outstanding which is $10,000. When we look at the book value for this one share, it is 70 cents.
To get the valuation of a business, value this tiny share exactly the same that we had valued the entire business as a whole. Now, we learned different valuation techniques in lesson 2 and lesson 3, so here’s a little something new here: price to earnings ratio. This is everyone’s favorite term. It’s often referred to as the PE of the business. All you have to do is take the market price which is the P, divide the P by E, the market price divided by the EPS. That is the earnings per share. For Nancy’s business, if we had one share, we know that the market price is $10. We take that $10 dollars divided by the EPS, and that’s the profit. The bottom line profit for one year is $2. Divide that number and you end up with a ratio of 5. There are no units on that when you divide a dollar by a dollar, so the ratio is 5. That would be your PE.
The Price to Earning Ratio: P/E
P = Market Price = $10
E = EPS = $2
P/E = $10/$2 = 5
What does the 5 mean? The best way to describe the PE ratio is to remember this phrase:
For every [PE ratio] dollar I spend buying this stock, I should receive 1 dollar in profit after a year.
That’s a really powerful sentence to remember. Take it down because that sentence applies to any company. If you’re talking about something on the New York stock exchange right now, you can apply that sentence to the PE ratio. Let’s say that the PE ratio is $10 for a company. You’d say, “For every $10 I spend buying this stock, I should receive one dollar in profit a year later.” As you can see, the higher the PE ratio is, the worse the sentence sounds. When you start talking PE ratio, you are obviously looking for something lower, because that a lot better than something higher.
To figure that out, you’re taking the current market price of what the company is trading for, and then you just divide it by the EPS. When we look at the whole business vs. one share, it doesn’t matter whether you are valuing the entire business or you are just valuing one share. When we look at the whole business, we know that net income or the profit is $20,000 a year and that the market price is $100,000. If you bought Nancy’s business for $100,000, you could expect to earn $20,000 on your net income one year later. Your expected return in one year would be 20%, because 20 divided by 100 is 20%.
Now, let’s look at the numbers for the one share. Take those numbers and divide it by 10,000 since that’s the number of Shares Outstanding. That will represent the value of one share. You can see that the earnings are $2 and that the market price is $10. The expected return in one year is the same thing – 20%.
A lot of people think that buying one share is different from buying an entire business. That is absolutely FALSE. Every time you look at just one share, you need to look at it as if you are valuing the entire business. If you buy one share from Apple, you might as well buy the entire thing because all the numbers are proportional. That is something fundamental in value investing.
Why is stock investing so lucrative? For example, would you buy Nancy’s ice cream stand for a million dollars? How would you answer that question? Most likely, you will laugh and say “Absolutely not.” Would you buy GE business for 2 trillion dollars? GE is famous all around the world. That’s a lot harder question to answer for most people. If it were 2 billion to 2 trillion, those numbers wouldn’t make sense to most people. Again, do proportioning. With GE, the current market price is 204 billion dollars. 10 times of that would be around 2 trillion dollars. The question about the ice cream stand is totally ridiculous, and the question about GE was equally ridiculous. GE was the same amount over the actual price.
I brought this up to highlight the difference that most people have. Once you start getting past the million dollars or 10 million dollar market, most people have no clue what the value of something is. It doesn’t even make sense to them. It further gets complicated when you take a large business and chop it up into millions and billion of shares. Now, you are saying all other companies are $20 a share. That means nothing to people; they just don’t understand it. If you value one share of a business like you value a whole business, success is on your way when you get involved in the stock market.
Understand that if a person bought the ice cream stand, they will do the hard math and typically purchase something like that based out of numbers. In the stock market, a lot of people know what you’re doing, but those people don’t know what they’re doing. What they do is they trade on a motion. They never fully understand what’s actually happening with the number. They have no idea what the value of the company that size is already.
The reason why stocks are lucrative is because a lot of people are trading on a motion. They’re saying, “Oh, well, you know, I have GE washer down in my basement and it’s really good. I really like it so I’m going to buy shares of that company.” It is a scary investment approach when people think that they can be successful and they might be paying 10 times the value of the company. To answer the question, emotional trading offers really cheap prices and really expensive prices. Your job is to always calculate the intrinsic value of the business regardless of the size, then compare the value to the price it trades for.
That pretty much summarizes the lesson objectives in this lesson. I just want to highlight that at the bottom of the page in lesson 4, I have a practice exercise column that shows all the terminologies that we have been learning through the past 4 lessons.
In lesson four, we learned that a share of a business is one unit of the overall business. For example, if an ice cream stand business was worth $100,000 dollars and the owner divided the company into 10,000 shares, each share would be worth $10. In this scenario, the 10,000 shares that the company would be divided into would be called the “shares outstanding.”
Just like a business, that becomes more or less valuable, 1 share of a business will do the same. Although we have only learned basic valuation techniques during the three previous lessons, we know that the earnings per share (EPS)-or just earnings- is one of the most important term to understand. The earnings per share (EPS) essentially tells us the profit that 1 share has made in a 1 year period.
Also, we learned that the book value (or equity per share) is a very important term because it provides the value of 1 share if the business stopped operations. A comparison of the book value and trading price (or market price) determines our margin of safety on each investment.
During the video, we learned that it is important to look at 1 share as if it were a mini-business, because it is easy to proportionally look at the value of the entire business that way. We also learned that owning 1 share is no different than owning the entire business.