How to buy low and sell high

“Wow, bitcoin is down to $40,000. What a great deal. I’m going to invest all my money in it!” ― random young person who thinks they’ll be a cryptozillionare

Welcome to the latest post in my journey to build financial literacy for young adults. As mentioned in my last two posts, the next few topics are going to be on some basics of investing, with today’s focused on how to value an investment. I hope that you bear with these posts even though they may be a bit more “boring” as you do need to know the basics in order to be a good investor.

I’ve often heard people provide the advice that “buy low and sell high” is the simple secret to growing your money. My instant thought on hearing that has always been “yeah, that’s as insightful as saying: you win a game by scoring more points than your opponent.” It sounds so simple to do, but how do you actually help me understand what price is low or high??? That’s where the skill of being able to value an investment is critical. Developing this skill helps you understand whether the current price is low or high and at a level where you’d either want to make that investment or sell what you already own.

At the most basic level, an investment can be valued based on the simple process of adding all the cash flows you get from that investment and subtracting those from the money you paid to buy it. The return you earn is the net payment you received as a percentage of your initial investment. For example, if I told you that I’d repay you in two installments of $0.55 each for your lending me $1 today, your return on that investment would be 10%

• Cost = $1 that you lent me
• Cash flows = $1.10 ($0.55 per installment x 2)
• Total return = ($1.10 - $1.00) / $1.00 = 10%

You can use this framework to value any investment, whether a stock, bond, real estate, cryptocurrencies, collectibles or something as simple as a bank account. For example, here’s the hypothetical return from a stock held for 5 years that was bought and sold at the same price, but received yearly dividends:

• Cost (money spent) = $10 cost of share
• Cash flows (monies received) = $1.50 ($0.20 for first two years, $0.30 dividend for third year and $0.40 dividends for each of the last two years)
• Sale price (money received) = $10
• Total return = (($1.50 + $10.00) - $10.00) / $10.00 = 15%; on an average annual basis, it’s 2.83%

Now, if only life were as easy as this example, it would be so easy to buy low and sell high all the time. Unfortunately, you won’t know most of the numbers used in this framework as you can’t tell the future. For example, if you buy a stock, you don’t know today what each year’s dividend will be nor will you know the price at which you’ll be able to sell the stock. In addition, there is the complication of understanding the value of a dollar today versus a dollar tomorrow. Because of inflation, a dollar today is worth more than a dollar tomorrow which is worth more than a dollar the day after. That’s why many analysts use a methodology which utilizes the framework above but adds in an adjustment for the time value of money called a discounted cash flow analysis (DCF).

DCF takes cash flows for each of the years that you own an asset and deflates the value of future cash flows using a discount rate (which can be based on inflation, your personal hurdle rate of investment or a company’s weighted average cost of capital). The following is the formula for a DCF as explained on the Corporate Finance Institute’s website (https://corporatefinanceinstitute.com/resources/knowledge/valuation/dcf-formula-guide/). Please feel free to spend some time looking through that site if you’d like to learn more as it provides a good amount of detail on DCF analyses.

DCF = (CF/(1+r)^1) + (CF/(1+r)^2) + (CF/(1+r)^3) + … + (CF/(1+r)^n)

Where:

CF = Cash Flow in the Period

r = the interest rate or discount rate

n = the period number

In an ideal world, you would be able to value any investment opportunity by developing estimates of the various cash flows from that investment and then applying the discount rate to build out a valuation for that investment. In fact, this is what a lot of analysts on Wall Street spend a great deal of time doing.

As DCFs require many estimates and assumptions, they do not provide a perfect valuation. A prudent way of using DCF is to develop a range of potential valuations based on a range of assumptions. Once you have a valuation range, you compare that to the current price to determine if making that investment today is more likely at the “high” or “low” end of actual value.

Because of the inherent uncertainty in valuations from a pure DCF, many investors either replace or supplement their DCFs with a number of valuation shortcuts. For today’s article, I’m going to focus on stock market valuation shortcuts, of which there are a number that investors use. Each of these has strengths and weaknesses so I wouldn’t rely on any individual one to make investment decisions. I’ve provided a brief overview below of each of these shortcuts from a great Investopedia article. The article provides a lot more detail on each shortcut, how it works and their strengths / weaknesses. You can access the article at: https://www.investopedia.com/articles/fundamental-analysis/09/five-must-have-metrics-value-investors.asp

PE ratio: The price-to-earnings ratio (P/E ratio) is a metric that helps investors determine the market value of a stock compared to the company's earnings. The P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. This is the most commonly used shortcut and provides insight into how much a company’s earnings are valued

PEG ratio: The price/earnings-to-growth (PEG ratio) is a modified version of the P/E ratio that also takes earnings growth into account. It is a slightly more detailed version of the P/E ratio which also gives investors insight into the rate at which earnings are expected to rise. As earnings are what drive long-term cash flows, this additional information does have extra explanatory value

P/B ratio: The price-to-book ratio or P/B ratio measures whether a stock is over or undervalued by comparing the net value (assets - liabilities) of a company to its market capitalization. This ratio helps investors understand how the market is currently valuing a company relative to a more conservative valuation of its assets (an accounting-based value called book value)

D/E ratio: The debt-to-equity ratio is a stock metric that helps investors determine how a company finances its assets. The ratio shows the proportion of equity to debt a company is using to finance its assets. This shortcut helps investors understand the riskiness of a company versus others in its industry

FCF: Free cash flow (FCF) is the cash produced by a company through its operations, minus the cost of expenditures. In other words, free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures. This metric provides investors an idea of the money the company has left over to reward its shareholders after what’s needed to keep the business going

There are many providers and sites which can give you data on these shortcuts so it’s much easier to use them than to build a DCF. From my perspective though, the ideal way to use them is to look at a combination of them and, ideally, your own DCF and then compare the valuation to companies in a similar industry to determine if the relative valuation is high or low. This information should give you a much more informed way of determining if you’re “buying low” or “selling high” when you’re trying to grow your money.

Thank you again for joining me on my journey to build financial literacy for young adults. If you have any questions on today’s post of if there are any topics you’re interested in my writing about, please let me know. I can be reached at [email protected].