Jun 15, 2009|
Do you buy a stock, or stake in a business?
It is well known how Warren Buffett invests in the stock market with a 'business perspective'. His mentor, Benjamin Graham once said that investment is most intelligent when it is most businesslike, a philosophy Buffett has said is at the core of all of his investing decisions. But what does that really mean and what are the implications of that for an investor?
There's a lot of wisdom one can draw from that one statement. But central to that is to think of investing in a stock like you would if you were to buy an entire business. Take for example a situation where your corner grocery store is up for sale, and you are interested in buying it. What would be one of the first things you will do? Most probably, check the price at which it is selling for. And at the same time, compare it to what the store is capable of earning on a yearly basis.
So, if for example it earns about Rs. 100,000 annually, and if it were up for sale for Rs. 1,000,000, it would be evident that you would be earning about 10% annually on your investment by buying the store. But by thinking of it in this way, it would become clear to you that the return on your investment you make is very intimately related to the price at which you buy the business in the first place. Thus, if the same business were up for sale at a price of Rs. 2,000,000, you wouldn't be earning more than 5% on your investment annually (Rs.100,000 divided by Rs. 2,000,000). And if the price were to be a very hefty 10,000,000, your return a measly 1%. Surely, something you would not be willing to touch would you?
But the sad truth is that investors end up buying such expensively priced businesses on the stock market all the time. And they do not have any reservations in buying it without as much as a thought about the price they are paying. More often than not, this comes on the back of supposedly amazing 'growth prospects' of the company. A ubiquitous feature of the stock market is people not knowing just how much is enough to pay for a stock which is said to have great growth prospects. And thus inevitably becoming vulnerable to subjectivity and emotions prevailing in the market at the time.
The P/E (price to earnings) ratio commonly used in stock market parlance is nothing but another way to look at the price at which a business is selling in relation to its earnings. Taking ahead our above example of the grocery store selling at various prices, a price of Rs. 1,000,000 for it would mean a P/E of 10 (Rs. 1,000,000 divided by Rs. 100,000). Similarly, a price of Rs. 2,000,000 and Rs. 10,000,000 would mean a P/E of 20 and 100 respectively.
So the next time you are willing to pay a certain price for a stock, take a closer look at that price. Have a look at its P/E ratio and be wary of the implications that has on your returns as an investor.
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