How to value a stock
Peter Lynch, the famous stock analyst, famously said that you should spend as much time picking a stock as much as you would spend buying a refrigerator. What are the characteristics of a good stock?
1. A good business plan. Seems simple enough, but there is an endless series of failed businesses that have been based on the idea of selling something for $9 that costs $10 to make. Examine the business as if you were the owner trying to make the business work. Then examine the business as if you were the customer. If the plan is too complicated to understand, that’s an indication of a poor business plan.
2. A low price to earnings ratio. This is the amount of annual profit per stock share compared to the price of the stock. If it’s more than 20, which works out to a return of less than 1/20 or 5%, why not put your money in a bank account instead?
3. Stable earnings.
4. Protection from competition. Imagine what it would take to launch a new cola — billions of dollars to match the amount of money Coca Cola and Pepsi have spent over the years to popularize their sodas. Each soda has a particular taste that people grow addicted to. Drug companies are protected from competion by patents. An important point is that the amount of money you need to spend isn’t a form of protection by itself. Billions have been spent on the airline industry without a cent of profit. To create a successful airline you’d somehow have to make people particular to your brand. Nobody has ever really done this in the airline industry, because an airline flight is an airline flight.
5. No barriers to growth. Restaurants are a classic example of difficult to grow business — one chef can only serve so many restaurants. Software is an example of a nearly infinitely scalable business since you can make more copies of your product for only a small additional amount of money and effort.
