Have you bought any stock lately? I'm talking shares of a single company into which you have put your faith and your hard earned dollar.
What did you know about this company and why did you buy it? Whatever the reason, I ask you to take a moment and reflect on the fundamental nature of the stock investing process so you can make a wiser decision the next time you buy.
Understand What You Own First: Understand what you fundamentally own.
As a shareholder, you own a pro rated share of the earnings that flow to the Net Worth of the company.
Net Worth is what is left after adding all the firm's assets and subtracting all its liabilities - free and clear for the company's shareholders.
Net Worth is also called Shareholder's Equity or Book Value.
When the Book Value is divided by the total shares issued, we get Book Value per Share.
Return on Equity Now what you need to find out is the return the company earns on its Net Worth.
This return is also called the Return on Equity and simply calculates the company's earnings as a percentage of Book Value.
If a company earns $2 per share and has a Book Value of $10 per share, its Return on Equity is 20%.
Easy! Look at the company's historical Return on Equity over the past 5 - 10 years.
Is it consistent or highly variable? For example, Wal-Mart delivered steady earnings and consistent returns, while Ford made a fortune for three years then lost money in the next two years.
Steady Eddie, like Wal-Mart, is better than fickle Ford.
Know the Company Get to know the company a little better.
Do they dominate their market? Are they in a business where it's difficult for a new company to enter? For example, you and I could wake up one morning with a couple of bucks in our pockets and start a restaurant pretty easily, but we couldn't compete with a Johnson & Johnson.
So pick a business with a high barrier to entry - the higher the better, and safer.
Don't Overpay Now it gets interesting, because even if you have all these ducks in a row, what you pay for the shares will determine the extent of your success.
If you pay too much, even for a great company with terrific earnings and management, you could lose your shirt.
Think about it.
Say you decide to buy a dry cleaner, and its net worth is $100,000 and it earns $20,000 a year after salaries and expenses.
If you pay $100,000, you earn a 20% return on your investment - fine! If you pay $1 million, you only earn a 2% return for all your effort - worth it? Of course not! And if the business turns "soft" you could lose money pretty quickly.
The key to wealth is keeping your losses to a minimum.
Yet, people pay too much for companies all the time.
Case in point: 10 years ago, investors took a shine to Wal-Mart and bid-up its shares to the point where their returns were only 2 ¼%.
Then, its stock stagnated even though earnings grew nicely.
Today, Wal-Mart shares return close to 10% including dividends, which is not bad considering interest rates are at 2%.
Now, I am not recommending Wal-Mart but only using it to illustrate how calculating certain numbers can help you buy shares at the right price.
Conclusion So, have you bought a stock recently? Do you know what you own - the business, competitors, barriers to entry, Book Value, Return on Equity, etc.
? If not, then think again.
If insanity is doing the same things over and over again and expecting a different result, why would this time be any different?