In a perfect world, we'd know exactly what every company is worth. In that same world, we'd also be able to exchange cash and shares without worrying about friction costs like commissions, taxes, and SEC fees. With that perfect knowledge and cost-free trading, market-beating investing would be simple. We'd simply buy any company if it traded below its fair value, then turn around and sell it if it jumped past that level. And because we would know a firm's exact worth, there'd never be a question about what would be the right decision to make.
Unfortunately, this isn't a perfect world. We're forced to pay a broker for access to the market, and to pay the Securities and Exchange Commission for maintaining an orderly and fair playing field. Plus, if we manage to make a profitable trade, the federal and most state governments also expect a cut of the profits. Because of these costs, investment moves that would have made sense in a perfect world often don't make sense in ours.
For example, imagine you bought iPod maker Apple
In our world, however, you also have to consider how much you'd keep after all costs of selling. Say, for instance, that you're in the 25% federal and 5% state tax bracket, and that you itemize your taxes. After paying your taxes of $11.79, let's assume that you have $64.21 remaining after selling your share of Apple stock [$76 minus $11.79]. Your choice really becomes "Would I rather hold a $70 company trading at $76, or would I rather have about $64 in cash?"
Personally, I won't normally sell a company unless I can keep more than I think it is worth. In this example, I'd need an amount subtantially greater than $70 after taxes to make selling worthwhile. Why pay my broker and the government only to end up with a result worth less than had I done nothing? That's a primary reason why my wife still owns her shares of mall operator General Growth Properties
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In addition to the costs of selling, no matter how thorough our valuation models, they're all based on projections and estimates of the future. Slight changes to our assumptions could have dramatic effects on what we think the business is really worth. In his evaluations, Motley Fool Inside Value analyst Philip Durell uses a technique known as a discounted cash flow calculation to find bargains for subscribers. Using that method, last year he pegged pharmaceutical giant Pfizer
This is why it's so important to understand the business behind the stock, so that the numbers you use make realistic sense for the company. For instance, last June, I built a related model to calculate that banking giant Bank of America
Your weapon against uncertainty
Fortunately, value investing pioneer Benjamin Graham came up with a solution to this conundrum, which he called the margin of safety. To use Graham's margin, make your best projection of a company's true worth, then knock off a decent chunk from that value. If the firm's stock is trading below even that discounted price, then it's time to buy. On the flip side, the time to sell is when that stock is trading so far above its true worth that you'd keep a margin above the highest value you could realistically calculate for the business.
To illustrate, while I've often been accused of being a Cisco Systems
Conversely, if I happened to already own Cisco, I wouldn't be selling it unless I could keep at least $20.40 from the transaction. Not surprisingly, that's 20% above the high end of what I think it's worth. Thanks to brokerage commissions, SEC fees, and taxes, I'd probably need to sell it at around $24 to end up keeping that much. While this means that I wouldn't be buying Cisco at its recent price of around $18.50, I wouldn't be selling it right now, either. It's simply too close to its fair price to be worth the total costs of a transaction.
The Foolish bottom line
In the end, it's what you keep after all costs that really counts. Your job as an investor is to maximize your net worth. To do that, you must be focused on buying low enough to get a discount to a company's fair value and selling high enough to keep a surplus above its true worth. In between those prices, any moves just might cost you more than they're worth.
Do you like the idea of using both a company's true value and what you'll keep when all is said and done to tell you when to buy and when to sell? Take a free trial of Inside Value and see how it's done. Subscribe today, and you'll also receive a copy ofStocks 2006, the Fool's guide to the investing year ahead, absolutely free.
At the time of publication, Fool contributor and Inside Value team memberChuckSalettaowned shares of Bank of America, which is anIncome Investorrecommendation. At the time of publication, his wife owned shares of General Growth Properties. The Fool has adisclosure policy.