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Don't Buy Over-Priced Stocks (Companies)

Buying Stocks Without Gambling

I'd much rather call stocks companies and I'd urge you to consider buying an entire company before you buy a single share. Time shares are 1/52 of a home, or one week's value of the full value, so in order to consider buying a time share you must also consider the full price of the home. If you feel the home or condo is worth $52,000 then $1,000 seems like a fair price for the time share. Likewise, if a company is worth $1 million dollars and there are one million available shares, it seems as if $1 per share would be a fair price.

How do you value a company?

There are numerous formulas online to determine what a company is worth. Marcus Lemonis of The Profit uses a vague formula of [Assets - Liabilities + (Earnings X 3)]. Warren Buffett is much more conservative due to his mentor Benjamin Graham and uses a vague formula of [Assets - Liabilities], or Total Equity (also known as Book Value). Buffett only buys a company (stock) if the total equity equates to more than the total outstanding shares. Technically, every company that Warren Buffett buys could liquidate the next day for more money than the outstanding shares are worth. Not only that, Buffett also makes sure that the company has been in business long enough to withstand the wrath of a horrible economy, world wars, recessions and depressions, along with a longstanding dividend payment and increased earnings. But that sounds like a once in a life time opportunity, right?

Stop looking at charts and start looking at financial statements, if you can handle it, that is..

Warren Buffett's View of Following the Crowd

What do you look at before buying a COMPANY?

Hope for growth? Increased earnings? A chart that looks like a handicap access ramp that's too steep for a wheel chair to get up? What if I gave you the opportunity to buy a small company for $1 million dollars whereby you're the CEO that continues to make $350,000 for the next 10 years straight, staying even without growth for all 10 years? It sounds like a good deal because it's easy math to determine that you'll make a healthy profit. What if you only had the opportunity to buy 10% of this company for 10% of the cost and 10% of the returns? That would equate to the exact same profit percentage with a relatively smaller upfront investment. Adding a bunch of zeros to the example does not change the fact that it's a good investment.

Let's look at 2 companies with strong and weak financial statements:

Don't Buy Over-Priced Stocks

Liquidate Goldman

I didn't mention anything about the earnings yet because I want you to view these companies as homes. Buy a house and sell a house to liquidate the equity. If you buy GS for $67 Billion you could turn around and sell all of the assets, pay off the liabilities and end up with $19 Billion dollars! Keeping the company for the positive earnings ($5.5 Billion net profit per year in 2016) will be a bonus until we liquidate it. Owning all of GS would be nice but I don't personally have $67 Billion dollars so I'll own as many shares as I can afford because of the excellent share price today (8/29/16).

Deactivate Your Facebook Investment

Facebook talks and talks about their future gadgets, acquires tech companies and has the most incredible IT professionals working for them, never mind the infamous Mark Zuckerberg. I have nothing negative to say about the company other than what individuals and financial companies are paying for the stock. You could buy the entire company today for $363 Billion but only liquidate it for $23 Billion. Ouch. Hopefully you're earning a lot along the way or you will have over paid! Facebook in 2015 earned just under $3.7 Billion which means it would take 100 years to make your money back! Woah!

Why would you buy the entire company? Why would you buy half? And why would you buy one single share? Because they mentioned that they have a few inventions coming up? Facebook is a great company owned by a great man who's humble and smart to say the least, which is another reason why people to pay outrageous prices for his company. They want to be the wind behind his sail and I understand that, but it's too late to jump in. The current crowd of people have already taken all of the space behind the sail and you will not catch any of the wind at this point.

What is the right way to buy a stock?

Balance Sheet

Look at the balance sheet first to determine if the company has positive equity (Home worth $100,000 with a loan of $60,000 = Positive Equity) which means the Assets are much higher than the Liabilities. If the assets are higher than the liabilities (like Facebook and Goldman Sachs) be sure to also notice that the total Market Cap (stock X total shares) is LOWER than the total equity (like Goldman Sachs). Buying GS outright will allow you to liquidate with cash left over, Facebook will not. Buying Facebook outright is like a financially upside-down home that's worth $23 Billion and has a loan of $363 Billion.

Goldman Sachs (GS) is an investment banking company and it's one of the 30 stocks in the Dow Jones (DJIA). Their market cap is about $70 Billion based on their share price and I believe there's more value than that. Assets minus liabilities equals Equity, and the amount of equity is the liquidity amount. $861 Billion in assets minus $775 Billion in liabilities leaves GS with $86 Billion in equity. The amount of equity is bigger than the total market cap meaning the stock price needs to adjust up much more. In other words, if you have $70 Billion in your pocket you could buy the entire company, liquidate it, and be left with $16 Billion. By the way, the company also has $5.5 Billion in net profit each year, which is meaningless when the equity level is so high, but a complete bonus while the company stays in business. I bought this stock at an average of $158 per share through the middle of 2016. When the stock price gets over $200/share it will be closer to the total liquidity price, so until then I will continue to buy it.

I sold this investment in the early months of 2018 well over $250 per share and locking in long term capital gain profits. The stock price adjusted up as I suspected, not due to company growth, but due to the fact that it was under-priced in 2016.

Citigroup Inc (C) is an investment banking company founded in 1812 (Citibank is the parent company). Similarly to Goldman Sachs, a rich person could buy all of the open shares for $130 Billion, just to liquidate the company for $240 Billion in equity. Companies all have assets and liabilities, and liquidating means to sell the assets in order to pay off the liabilities. In the case of Citigroup, if one purchased the company they would be able to liquidate it the next day for $240 Billion. This rich person would get quite richer with a profit of $110 Billion. It seems like a no-brainer to invest in Citigroup and Goldman Sachs for the next 10 years.

Instead of putting all of my money into these companies I've decided to dollar-cost-average over the next 5 years, whereby investing equal amounts per month in order to continue buying it as the stock price lowers. I can also choose to buy less during months when the price is slightly inflated. I bought this stock at an average of $47 per share throughout the middle of 2016. I believe people will start to recognize that these companies are valued at half of their equity and the stock price will soon adjust back up. However, if and while it continues to lower I'll continue to buy it as a very cheap investment.

I sold this investment in the early months of 2018 well over $70 per share and locking in long term capital gain profits. The stock price adjusted up as I suspected, not due to company growth, but due to the fact that it was under-priced in 2016.

Citigroup NYSE:C Financial Analysis and Performance

Income Statement

Then look at the income statement and be sure to see positive earnings over the last 10 years, and hopefully increased earnings. Facebook's earnings continue to grow but aren't high enough to pay off the company within 5 years, it will take 100 years. Goldman Sachs will take about 15 years to pay off the company through earnings, however their total equity will be able to pay it off immediately, unlike Facebook. Therefore, GS has net profits that are a complete bonus because if the earnings ever turn negative due to a poor economy, they could liquidate and still end positive.

Toyota Motors (TM) is a multinational automobile manufacturer in Japan with over 350,000 employees and the highest sales of hybrid electric vehicles in 2017. Once their net income from 2017 ended up on the balance sheet in 2018, Toyota currently has roughly $180 Billion in Book Value or Net Tangible Assets (Equity minus Intangible Assets) which means the CEO could close the doors of operations, sell off the assets, pay off the liabilities and have $180 Billion left over. If a billionaire wanted to buy all of the shares of the company at the current price of $130 per share (3/30/18) it would cost $185 Billion which is a $5 Billion premium to the book value.

The average net income for Toyota over the past 4 years (2014-2017) is roughly $17.5 Billion. The fact that the book value is equal to the market capitalization makes this a low risk investment, and the incredible earning power of Toyota is going to increase the book value over the next 5 years as well. I just started to buy TM in March of 2018 at $130 and will continue to buy it as it lowers. I believe the Trade War will lower the stock price even more, and if it does, I'll continue to buy. If I were to value the company based on a formula of [Book Value + (Net Income x 5 years)] TM would be worth roughly $190 per share. I plan to sell the stock when it's near $200 per share.

Rental Income

A home worth $200,000 with a loan of $100,000 is a comfortable situation to be in. Rental income on top of that is a bonus. However, the scary part about rental property is that you may not find a tenant. In this case, however, if you go 6 months without rent you can sell the home and still end up with $100,000 cash; Goldman Sachs. Whether I own 1% or 100% of this home, company or stock (whatever you prefer to call it) I'll feel comfortable with my investment.

A home worth $100,000 with a loan of $200,000 is not a comfortable situation to be in. Including rental income into the scenario makes it even more confusing and scary because it can't sell for positive cash (equity). But when 6 months go by without a tenant, you have a very difficult choice to make.

Dow Jones Stocks Compared to Facebook

There are 30 stocks in the Dow Jones Industrial Average (DJIA). When your friend says "The market was down today!" he or she is referencing the price of the DJIA, or the combination of all 30 stocks that represent it. It's a perfectly diversified group of companies, each being the best in its particular industry (McDonalds, Coca Cola, Exxon Mobil, etc.). Wouldn't you be interested to know that you can buy 27 out of 30 of the DJIA companies for cheaper than Facebook? That's right, 27/30 companies in the DJIA cost less, but make more, than Facebook. But if people continue to buy Facebook stock it will continue to go up, and might even be the most expensive company in the world. However, being the most expensive DOES NOT mean they are the most profitable, they simply cost the most to buy. Take a look at this chart:

Dow Jones Stocks Compared to Facebook

Facebook From Mark's View

Let's get something straight, Mark Zuckerberg is NOT in a bad situation, nor does he have negative cash or equity in anyway. He started the company and owns the majority without paying an outrageous price. You, my friend, however, need to purchase the company (or one share) today at a valuation of $363 Billion putting YOU in a bad financial situation, not him. He's a genius that could and should sell out at $363 Billion, but what's a few more Billion when you already have so much? He can just remain the king of his throne, why not.

In conclusion, I'm not trying to demote Facebook or promote Goldman Sachs, I'm merely trying to help you think about your investment before you buy, whether you buy one share or all of the shares of your preferred company. If you want to learn more about my style of thinking you should read these books because they taught me most of what I'm writing:

The Intelligent Investor

Benjamin Graham's (Warren Buffett's mentor) view on Value Investing.

The Millionaire Teacher

Brainless investing in "Index funds" and avoiding the high fees associated with "Mutual funds".

Written by: Chris Bell
Chris Bell Real Estate