1/25/2024 0 Comments The incredible shrinking alpha pdfHowever, the value that investors assign to businesses can change rapidly based on the broad psychology of all market participants. Large, established businesses don’t really change that much on a day-to-day basis. In the short-term, prices are primarily driven by investor psychology. 6:50 –Why do stock prices bounce around every day? The large number of variables is part of the reason stock prices bounce around every day. These are just a few simple examples of the many quantitative factors that impact valuations, but psychology also plays a huge role too. But if interest rates skyrocket to 8%, then that 1% return sounds awful. For example, buying a candy store for $100 million and earning a 1% return might be more tolerable if interest rates are 0%. If interest rates are 0%, then it can make a company with a high P/E (low return on investment) look more attractive. Prevailing interest rates also are important. So those factors can influence how much an investor should be willing to pay for a company.īroadly speaking, a higher purchase price may be justified for companies with more dependable profits or faster growing profits. Some companies can remain profitable and even grow their profits during bad periods, others cannot. Other businesses have highly variable profits when the economy is doing well, but profits fall to the floor when recession hits and demand wanes. ![]() There are also businesses that never generate a profit, so that prior calculation goes right out the window. Obviously, no such business exists that generates the same amount of profits in any given year forever. ![]() In the simple example above, we assume that profits from the candy store will be $1 million forever. There are a bunch of factors that change the P/E ratio. This is a ridiculously simple way to value a business, but it shows the relationship between a business’s profits and how much it should be worth. In this simple example, maybe I decide that a 10% return on my investment makes sense, which would be a P/E ratio of 10, so I would offer $10 million for the candy store. That suggests a $100 million purchase price is too high because I could stick my cash in Treasuries to earn more and not have the hassle of running a candy shop.ĭetermining a business’s valuation is the art of coming to a price that entices the seller to sell the business and entices the buyer to buy the business. The P/E ratio in this instance is 100 and the inverse of that gives me a 1% return on my investment each year. If I were to offer $100 million for the candy shop, that would probably be too high. That sounds like a great deal! Needless to say, $2 million is probably too low of a purchase price. To decide if that’s a good deal, you can take the inverse of the P/E ratio-so the earnings are $1 million and I paid $2 million for it, so that’s a 50% return on my investment. That means the P/E ratio of the deal is 2. If we had no idea what we were doing, perhaps Brian sells me the candy shop for $2 million. ![]() If Brian offers me the candy shop that nets $1 million in profits every year and wants to know how much I would pay for it. Imagine a simple candy shop that creates $1 million in profits every single year. Brian gives the following example to explain the P/E ratio, which is a very familiar term to many investors… There are several different ways to value a company, but one of the easiest is using a multiple of a company’s profits or net income at any given time. Here are some of my notes… 1:29 – How do investors determine what a business is worth? I work with lots of people who have been investing their whole life and yet they don’t truly understand the underlying fundamentals of investing. I’m updating my Amazon page to include this title now because I can tell that I will be giving out this book quite a bit in the future. I’m joined by Brian Feroldi, author of Why Does The Stock Market Go Up?: Everything You Should Have Been Taught About Investing In School, But Weren’t, which breaks down the most common questions everyday people have about the stock market and investing in easy-to-understand terms.īrian notes that this book was aimed at beginners, but I’d argue that even lifelong investors will find it to be a refreshing walk through the fundamentals of what makes stock prices change in the short- and long-term.
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