Why own shares of stock in the first place? Where does the “value” of a business come from? Why is share ownership often better than other investment choices?
Sometimes the best questions are the simplest. That doesn’t necessarily make the answers simple.
But, if put in the right context, almost everyone can understand where the value of a business comes from. (And once we learn that, it’s an easy step to figuring out why purchasing shares in good businesses at reasonable prices has often been so rewarding.)
First, let’s start with an exciting problem. Assume (for a moment) you have a million dollars to invest. What if one of the many things you could do with that money is to buy a house. (Of course, a million dollars is a lot to pay for a house of any kind, but let’s see.)
What would you like to know before deciding whether paying a million dollars for that house was reasonable? What if I told you that you could rent that home out for $80,000 per year net of all the costs of maintaining that home? Would that help justify the one-million-dollar purchase price?
Let’s see. Invest one million dollars in a house. Rent it out for $80,000 dollars per year (net of all costs of maintaining the house, including real estate taxes, etc.). That means you would be earning $80,000 per year on an investment of $1,000,000 to buy the house, for an 8% annual return on your investment!
That doesn’t sound too bad. Especially, if you could only earn 1% or 2% per year by putting that same million dollars into a savings account at the bank. A 1% or 2% return from your savings account would equal annual earnings of only $10,000 or $20,000, far less than the $80,000 you could earn by buying the house and renting it out.
Maybe paying $1 million for that house isn’t such a bad deal after all?
But before laying out that kind of money (even theoretical money), perhaps knowing a little more information would be helpful?
How about this? What if I also told you that similar houses whether on the same block, in the same town or in the town next door have recently sold for closer to $1.3 million on average. Would that help? In other words, does it make you feel better that this house is priced inexpensively relative to other similar houses?
It probably would.
So, there it is. Figuring out whether buying a home for a million dollars is a good deal or not isn’t very mysterious. If you could earn a lot each year by renting out the house compared to the total cost of the house–that would be a good indicator (remember, $80,000 in rent divided by $1,000,000 purchase price equals an 8% return each year on your investment). And, if it’s available at a lower price relative to other similar houses, even better. That would be another good sign. Maybe you’d also want to believe that the neighborhood is heading in the right direction and likely to remain a nice place to live for a long time to come. But that’s about it.
With just those few simple considerations, we’re off to a great start in trying to figuring out whether buying that house for a million dollars is a good deal and a smart investment.
And believe it or not, we also just learned some of the key considerations when we’re trying to value a business!
So, let’s take what we just learned about buying a house and apply the same type of thinking to deciding whether to take our (fictional) million dollars and buy a business instead.
The local candy store, Jason’s Gum Shop, is for sale and the asking price is also a million dollars. Boy, that sure sounds like a lot of money to ask for a local candy store. But let’s check out the facts anyway.
Last year, Jason’s Gum Shop had $600,000 in sales, $500,000 in expenses, and earnings of $100,000 (don’t worry, it’s the healthy kind of candy—no sugar, no artificial sweeteners, lots of nutrients—you know, a made-up candy store that only exists in Fantasyland and at Invest5 University).
Anyway, the store earned $100,000 after all expenses and Jason wants you to pay him $1 million to buy the store. Does that make sense?
Hmmm. Invest $1 million and buy the store, earn $100,000 after all expenses, that’s $100,000 divided by $1,000,000 or a 10% annual return on a million-dollar investment. That’s even a higher annual return than we’d get from buying and renting out the house!
Should we buy it? Well, we should probably ask a few more questions.