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What To Look For In An Investment

What is the price of the entire company?

You need to look at the price of the entire company. The "cost" of acquiring the entire corporation is called market capitalization. The market cap is the price of all outstanding shares of common stock multiplied by the price per share at any given moment. A business with one million shares outstanding and a stock price of $50 per share would have a market cap of $50 million.

This market capitalization test can help keep you from overpaying for a stock. At one point during the boom, eBay had the same market cap as the entire General Motors Corporation. In fiscal 2000, General Motors made $3.96 billion dollars while eBay made only $48.3 million. Yet were you to buy either one, you would have had to pay the same amount. It’s unbelievable that any sane investor would pay the same price for both companies but the general public was seduced by visions of quick profits and easy cash.

Another useful tool to help gauge the relative cost of a stock is the price to earnings ratio (or p/e ratio for short). It provides a valuable standard of comparison for alternative investment opportunities.

Is the company buying back shares?

One of the most important keys to investing is that overall corporate growth is not as important as per-share growth. A company could have the same profit, sales and revenue for five consecutive years, but create large returns for investors by reducing the total number of outstanding shares.

Think of your investment like a large pizza. Each slice represents one share of stock. Would you rather have part of a pizza that was cut into ten slices or one that was cut into eight slices? The pizza that was only cut into eight parts will have bigger slices with more cheese and toppings.

A shareholder should desire a management that has an active policy of reducing the number of outstanding shares if alternative uses of capital are not as attractive, thus making each investor's stake in the company bigger. When the corporate "pie" is cut into fewer pieces, each share represents a greater percentage ownership in the profits and assets of the business. Tragically, many business managers focus on domain building rather than increasing the wealth of shareholders.

What are your reasons for investing in the company?

Before you purchase stock in a company, you need to ask yourself why you are interested in investing in that particular opportunity. It is dangerous to fall in love with a corporation and buy it solely because you feel fondly for its products or people - after all, the best company in the world is a lousy investment if you pay too much for it.

Make sure the fundamentals of the company (current price, profits, good management, etc.) are the only reason you are investing. Anything else is based on your emotions; this leads to speculation rather than intelligent investing. You have to remove your feelings from the equation and select your investments based on the cold, hard data. This requires patience and the willingness to walk away from a potential stock position if it does not appear to be fairly valued or undervalued.

Are you willing to own the stock for the next ten years?

If you aren't willing to buy shares in a company and forget about them for the next ten years, you really have no business owning those shares at all. The simple but painful truth of this is evident on Wall Street every day. Professional money managers attempt to beat the Dow Jones Industrial Average, which is a collection of 30 largely unmanaged stocks. Year after year, they fail to do this. It seems impossible that a portfolio managed by the best minds in finance can't beat an unmanaged portfolio of long-term stocks held indefinitely.

The guaranteed way to success has historically been to select a great company, pay as little as possible for the initial stake, begin a dollar cost averaging program, reinvest the dividends and leave the position alone for several decades.

Carlos C. Johnson III, Founder

The UnderCover Millionaire