Good companies to not always equate to good investments. Valuating a company properly is step number one in filtering for good investments.
I've heard the following investment advice:
You should invest in what you believe in.
I think the following captures the point better:
You should believe in what you invest in.
At first these two statements seem to be saying similar things, but in reality, I think the similarities are dwarfed by their differences.
Let's look at an example. Imagine some company, MOON, is trading for $100/share. I feel that MOON is a fantastic company. They sell real estate on the moon and I'm convinced MOON is the future of real estate. The notion of "You should invest in what you believe in" would suggest that I buy some shares of MOON, and actively invest in them, because I believe in them. On the other hand, "You should believe in what you invest in" doesn't suggest this at all. It does not take a position on what I should invest in; it says that if I choose to invest, I should believe in that company.
I bring this distinction up to highlight the following point: The fact that you believe a company is fantastic, does not necessarily mean its worth investing in (even if it really is a fantastic company).
Let's return to our MOON example. The first question you should be answering (for yourself) is how much do you think MOON is worth (feel free to take into account the fact that you think MOON is fantastic and will grow). Is the answer 1 Billion? 10 Billion?
Let's say your response is "10 Billion dollars!". What would you say if I told you that MOON has 200,000,000 (two hundred million) outstanding shares. Essentially, you can say that if you bought 1 share of MOON, your 1 share is 1 out of 200,000,000 shares available in the world.
Doing some quick math we determine that, since MOON is trading at $100/share and since 200,000,000 shares exist, the market is valuing MOON at $100 * 200,000,000 = $20Bn (20 billion dollars).
Would you still view this as an investment worth making? After all, you just told me that you feel MOON is worth $10Bn (however it was that you came to that conclusion).
Notice, this fact about MOON's value has nothing to do with whether or not MOON is a fantastic company or not. MOON is / is not a fantastic company regardless of whether or not it is a sound investment.
A natural follow-up question to the previous example is "Well, how do I decide how much I feel company is worth?".
This is the main question I hope to address in the upcoming posts.
To this end I suggest (and will try) in the following posts to pretend we live in a world where the stock market does not exist. There is really no use of the stock market aside from being able to buy and sell assets. Using stock prices or performance as an indicator of future performance is a common trap, at least for long term investors.
It is important to remember: The stock market does not necessarily reflect the state of the economy and the stock price does not necessarily reflect the state of the company.
To drive this point home we can briefly discuss a recent and famous example. I wont go into too much detail here, but recently GME (GameStop) experienced what is known as a short squeeze. The interesting part, for our discussion, is that investors, such as Michael Burry (remember him from last post? The guy who predicted the stock market crash of 2008!), bought shares of GME at ~$3 not in hopes of a short squeeze, but because they believed GME was undervalued. The reason they felt this was that the stock price for GME multiplied by the number of outstanding shares was less than GME book value. Meaning if GME went bankrupt and sold all its inventory and other assets to settle all of its outstanding debts, there would be more value remaining than what the stock market currently valued it at (which makes little sense).
This is what we may call a value play. It is clear that the market is undervaluing GME (Even though GME may not be a great company. Afterall, whose buying console CD's nowadays?).
Starting in the next post we will look at a companies annual report (10k). This report is filed yearly by every single public company. It contains all the financial information necessary for us (as investors) to understand the value of a company. It describes the companies debt, assets, equity, outlook (from the management's perspective), etc.
Together, we will work our way through a 10k, working hard to understand each section and learn what exactly it can tell us about the company.
The overarching goal will be to one day be able to read a 10k and determine what we feel the true value of the company is. That way we can then look at what value the market as assigned that company and make educated buy/sell decisions.
[Edited by: Elliot Eisenberg] 🙏