WELLNESS & WELL-BEING
How Do You Learn to
Invest in Stocks?
LESSON THREE
By Donald Broughton
T
wo months ago, we talked about these basics: Index
funds participate on the way up, but also participate on
the way down; buying individual stocks can allow you
to capture the upside, and not fully participate on the
downside; look at what you are spending your money
on, and find companies that can sell more at higher prices.
Last month, we reviewed digging in, reading and learning how the
company generates revenue and makes profit, and how to figure out
what the market thinks it is worth.
First, we have to make a legal disclaimer: This is not a solicitation.
If you do something I suggested, and it doesn’t work out, I am not
responsible. Investing in stocks involves risk, and you can lose all your
money. All right, now, let’s keep talking about one of my favorite topics.
Back to our valuation discussion last month.
If you could invest in a bond that yielded 5 percent, why would you buy
a stock with a price-earnings ratio of more than 20? Simple: Over time, as
the company’s revenue and earnings grow, the stock should appreciate in
value. In our example, at the end of 10 years, the bond would have paid you
$50 a year in interest, and you would get your principle of $1,000 back. If
you bought a stock with a similar earnings yield (or P/E of 20), and the
company’s earnings grew by 10 percent a year for 10 years, the company’s
earnings would be just less than $130. If the stock was still valued for a P/E
of 20, then the shares would trade for just less than $2,600 a share, and
the compound annual rate of return would be ~10 percent. Even when
you take into account not getting that $50 a year in interest payment, the
stock produces a higher potential return.
This is where things can get interesting. What if the market - over
time – has improved its view and increased its estimate of how much
earnings will grow, and as a result, has increased the valuation multiple
being paid for shares from 20 times to 30 times? In this scenario, the
shares would be valued for $3,900 a share, and your compound annual
rate of return would be 14.6 percent.
One of my greatest investing mentors said he only bought stocks
when he could expect two things: a higher rate of earnings growth
than the market was expecting, and that over time, the market would
increase the valuation and earnings multiple it was willing to pay. This
is one of the best stock investing rules anyone can ever learn.
The inverse of this can be very dangerous and was at the root
of the “dot-com” market crash in 2000. Many of the companies
that surged in value in 1998 and 1999, and crashed in 2000, are
still in business and have grown earnings significantly since then.
The problem was that when the stocks were selling for 200 or 300
times earnings (as many were), there wasn’t any room to reasonably
expect the valuations to increase.
So, keep these three rules in mind. Rule No. 1: Find a company that
can sell more at higher prices. Rule No. 2: Dig in, read, and learn how the
company generates revenue, makes profit, and what the market thinks it
is worth. Rule No. 3: Invest in companies that can grow earnings faster
than expected, and sell for higher valuation multiples than they do now.
As founder and managing partner of Broughton
Capital, Broughton is a frequent guest on CNBC,
“Nightly Business Report” and Fox. He is regularly
quoted in The Wall Street Journal, where he is also
recognized as a top stock picker, as he is by Fortune,
Zacks and StarMine.
SAVVY I SOPHISTICATED I SASSY
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