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The worst reason to buy a stock

Penny stocks can be both disasters and goldmines, but don't forget to count the slices.

A family friend recently explained to me how he intended to double his money in the stock market. He had found a company that was cheap. Dirt cheap, in fact – the shares were trading at just one cent. ‘At one cent, all the stock has to do is go up another cent and I’ll have doubled my money,’ is roughly how he put it. 

If you’re reading this, there’s a good chance that you have above-average financial literacy, so this article may be an empty exercise. But I’ve heard the ‘one cent’ line of reasoning so many times over the years that it seems endemic among people new to investing (and even a few seasoned travellers). Sometimes it’s worth explaining the seemingly obvious because, at some point in everyone’s history, it probably wasn’t that obvious.


One piece, or two?

In ordinary life, we’re used to equating price with value. For the most part, a $15 hamburger at a restaurant is going to be better quality than a $5 one from Hungry Jacks. But in the financial universe, share prices are completely unrelated to both the quality of the underlying company and whether buying the stock is a good or bad investment.

Companies can issue shares and buy back stock whenever they like, so there are huge differences in the number of shares each company has outstanding.

CSL, for example, has 452 million shares. In other words, the company is split into 452 million slices, and each of those slices is currently trading on the ASX for $142 a piece. Multiply those two numbers together and you get the company’s total valuation, or ‘market capitalisation’ – in this case, $64bn. Computershare, on the other hand, has decided to slice its pie into 543 million pieces, and each of those is trading on the ASX for $16. Computershare’s market capitalisation is $8.9bn.

As things stand, CSL is a much larger company than Computershare, and its shares trade for a higher price. But that isn’t always the case. BHP Billiton, for example, is more than twice the size of CSL, yet its share price is only $30 because it has billions of shares.

What’s more, CSL’s management could wake up tomorrow and decide to do a ‘share split’ so that each current share is divided into, say, 10. Its share price would instantly fall from $142 to $14.20 – but the total size of the company and your investment, in dollar terms, would be unchanged.


Price ≠ value

The stockmarket works like an auction, with people bidding for and selling their shares in a company. As with property auctions, prices can occasionally be completely out-of-whack with what the shares are actually worth – the underlying intrinsic value per share, which is a function of all the cash the stock will throw off between now and judgement day. To work that out, you need to consider what the company earns, its forecast growth rate, future margins, competitive position etc. (Don’t worry, that’s what the Intelligent Investor analysts like to think about all day. We're here to help).

In the case of CSL and Computershare, we believe that CSL’s true intrinsic value is above where the current share price is, and that Computershare’s is below it.

You may have spotted the opportunity. CSL is undervalued and Computershare is overvalued. CSL is likely to lead to better long-term returns, partly because you’re buying with a ‘margin of safety’. This is what value investing is all about: finding above-average businesses and buying them at a discount to their intrinsic value.

That CSL is a better investment than Computershare has little to do with which company has better operations (indeed, they’re both well managed, high-quality companies). And the reason has absolutely nothing to do with their share prices alone. What matters is where their share prices stand relative to their intrinsic value. A stock trading for one cent can be overvalued, and a stock trading for $150 can be undervalued.


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