This is a Best Of revision of an article David Forrest wrote in October 2001.
I believe many investors are too cavalier about stock purchases. Buying stock is as easy as Sunday morning, and many captains are navigating between Scylla and Charybdis with nary more than a price-to-earnings (P/E) ratio as compass. My humble supplication to you, dear reader, is that from this moment forward, in every stock purchase you make, please ask yourself:
"Would I buy the whole freakin' company?"
For the sake of simplicity, I'll retire for a moment from the mind-boggling numbers associated with the purchase of Amazon.com -- most of us don't have $20 billion lying around -- and concentrate instead on a slightly more probable opportunity. Let's divert our attention to the local pizza parlor, shall we?
Let's suppose that sometime this weekend, you order your favorite pie. (Hawaiian, heavy on the pineapple.) When picking up this culinary delight, you casually mention to the owner how much you love her pizza. Noting how busy they are, you remark that she must have a very successful business, and she proceeds to tell you that while business is excellent, she's just been picked as a contestant on the next installment of Survivor.
Because she's so certain she'll win the $1 million top prize, she plans to sell the business and retire to Acapulco. Seeing the entrepreneurial glimmer in your eye, she offers to sell you Big Mamma's Pizzeria for $115,000. What would you do?
Before you drift in and out of consciousness at the thought of being surrounded by piles of pepperoni, stop. I'm not as interested in whether you should take Mamma's offer as I am with the way you'll decide whether to accept. Will you flip a coin? Ask your barber? Consult a psychic?
No, you'll need to do much more, and the rigor with which you approach the question of whether to buy the pizzeria is exactly the same rigor you should use for each and every stock purchase. As a stockholder of a company, you are already a part-owner of a business, so it follows that you should examine all purchases as if you were to pony up and buy the whole business.
Where will you begin?
Whether you're buying a pizzeria or a certificate of deposit (CD), it's natural to ask, "When will I get my money back, and how much will I make on the deal?" The answer has everything to do with the strength of the business you're buying -- and how much you're paying for it. For simplicity's sake, let's make two assumptions:
- You plan to be in the pizza business for five years.
- At the end of the five years, you'll be able to sell the business for exactly what you paid for it.
Knowing you'll get your original investment back in five years, you need to think about how much money you want to make each year from marking up the anchovies and bread sticks. What would be an acceptable rate of return for five years?
Let's say that to make your hard work worthwhile you require an annualized 15% return on your investment. How much would you need to make from the pizzeria each year to achieve this return? That 15%, compounded for five years, results in a total return on investment of 101%. At the end of the five years, in addition to the $115,000 you'll sell the joint for, you'll need to have pocketed an additional $116,300 to hit your target.
Again, to make things simple, we'll divide that $116,300 into five equal parts -- though in reality, it would likely be uneven -- and say that in order to achieve your desired rate of return, you'll need the pizzeria to yield $23,260 in profit per year.
Having thought about what kind of return on your investment you need, you now need to figure out if Big Mamma's Pizzeria is capable of generating the profits you require. The due diligence required to answer this question is exactly the kind of investigation you need to do with all stock purchases. Here's my shortlist of things I'd want to know about Big Mamma's:
- How much pizza does she sell each year? (Total sales)
- How much do things like pepperoni and dough cost? (Cost of goods sold)
- How much is she paying the pizza delivery guy and the cook? Does she do any advertising in local newspapers, Yellow Pages? (Selling, general, and administrative)
- How much will the ovens and delivery truck depreciate this year? (Depreciation and amortization)
- What kind of tax does her small business pay? (Income taxes)
In case you didn't notice, each one of those fairly simple questions is an item on a standard income statement. You needn't be spooked by these kinds of financial statements. They simply answer the common questions we should all have about a business.
Now that you have a basic idea of how the pizzeria is performing, you can make a few educated guesses about what kind of profits it can expect this year, which is a good start. But your investigation should also include:
- From whom will you buy your ingredients? (Vendor relationships)
- How will you have to pay them? Will you need to lay out a large chunk of cash each month to buy all the ingredients up front or is that something that you can purchase on a daily basis and pay as you go? (Cash flow)
- Does Big Mamma owe any money to the bank? Is she expecting you to pay off her note? (Debt)
- Are there competing pizza parlors in the neighborhood? How well are they doing? (Market research, competitive landscape, risk assessment)
- Is there room to grow Big Mamma's business? Might there be a call to open new stores or expand the current one to accommodate more customers? (Forecasting/planning growth)
Of course, these are only a few of the things you might ask about Big Mamma's Pizzeria before you consider laying out $115,000. Let's face it, you work your tail off to make your money, and if you're going to buy someone else's business, you should probably know it inside out and upside down. There's no way you're going to risk your money on something if you don't understand the risk you are undertaking to get the return you expect, right?
Assuming you agree, there's one more reason to make sure you never again buy 100 shares of TechStock.com (Ticker: PU) because you got a hot tip from that barber of yours.
The real question is whether you're willing to spend the time learning about Big Mamma's Pizzeria, Amazon.com, Tivo, or any other company. Are you? If not, you probably have no business investing in individual companies. Buy an index fund or CD instead. There's absolutely no reason to do otherwise unless you're extremely confident in your ability to beat the market.
If, on the other hand, you are willing to do the work, the first stop you should ever make in assessing a company's business prospects is the 10-K it files with the SEC. It tells you a lot about its business model and financial condition. Here's the 10-K for Amazon.com. Would you pay $20 billion for it?
To find out whether Fool co-founder David Gardner would pay $20 billion for Amazon.com or $455 million for TiVo, check outMotley Fool Stock Advisor.