moneyFYI
Financial Freedom Is Merely Organized Common Sense
Stocks Are Not Intuitive
Is being the dominant business in its sector good? Would a brand name that everyone knows matter? Would 330 million users help? Sales are over $3 billion and growing. Would $7 billion in cash and marketable investments matter.
After an eight year hold, would that leadership make you a profit as a shareholder?
You’d think so. But, no.
An example
Twitter was founded in 2006 and became a public company in 2013, On 29 November 2013, it traded for $41.57 per share. Eight Years later on 30 November 2021, it traded at $43.94. It paid no dividends in the interim. That’s compound annual growth of 0.7%. Hardly spectacular.
What’s that about?
Market penetration and visibility are important but creating profit matters more.
By the end of six years, 2019, profitability was more than 10% of sales, but the stock was at $33. 2020, recorded a loss from operations, but in early 2021 it traded up to $77. Later in the year a shareholder class action law suit settled for $800 million. That adversely affected quarterly earnings!
Then at the end of November founder Jack Dorsey resigned as chairman. The stock jumped $5, 11%. That had to hurt the chairman’s ego. Shareholders seemed pleased. Clear skies, new opportunities and all that.
Then they named their new chairman. By noon a day later the stock was under $44. Not much of a vote of confidence.
What’s the lesson?
Not every visible company is profitable. Ones like Coca Cola, or P&G have recognition and are profitable. Others were visible for a while but didn’t convert visibility to profitability. At the end of 2019 Zoom sold for $66.64 and by October 2020 was $559. But then it fell to $337. Now it is barely over $200. Still a nice trade from $66.64
To support high stock valuations you need three things.
- Earnings
- Cash Flow, and
- Growth
A company whose earnings are growing quickly will be valued at a higher multiple than other companies. But not unless those earning spin off some cash. In the early years it will all be reinvested to support the growth but eventually there must be cash. And dividends.
You can judge the success of a company by the ability to return cash to the shareholders. Many valuations systems rely only on that.
You should treat growth by acquisition as a separate decision. Some will be simply tactical. Buying a potential competitor and getting talent as part of the bargain. Others are strategic, real businesses that just happen to be under one roof. It is interesting to see how buying a business with a low earning per share multiple affects the share price of one that has a high multiple. If a company with a multiple of 15x can buy a business at a multiple of 10x, you’d expect it would in crease the acquiring companies total stock value by 5x the earnings of the acquired company. Sometimes it does, sometimes more because the combination is synergistic. Other times not because it dilutes the overall business.
Segmented financial information is helpful to decide future value expectations in terms of earnings and possibly multiples. Not easy to find though.
Your judgement matters. That includes management direction. Are they trying to be a profitable and useful business or trying to optimize short term numbers. Is the product getting better? Does management look after themselves before the shareholders? Are there smart competitors? Is the multiple likely to change because of changes in the economy? Is the company’s brand tarnished or under attack by the media.
The bits to take away
Famous names are not necessarily good stocks.
Have a way to evaluate that matches your needs. Look for the “Goldilocks yield” The one that gets you what you need with a minimum of downside risk. Quick profits are nice but they are more volatile. Be careful listening to stories of other’s successes.
Be like Buffett. Look for situations where you can say, “I don’t care if they close the stock market for 10 years after we buy the stock. We invest in businesses not stocks.” There is a difference.
Beware of Fear Of Missing Out. FOMO. You cannot buy everything. Have a fear of being involved with something with no likelihood of long term success. A single big loss could wipe out a whole series of success.
Help me please. If you have found this useful, please subscribe and forward it to others.
I build strategy and fact-based estate and income plans. The plans identify alternate ways and alternate timing to achieve both spending and estate distribution goals. In the past I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning, have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, Banks – from CIBC to the Business Development Bank.
Be in touch at 705-927-4770 or by email to don@moneyfyi.com
moneyFYI 