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Note to reader: This article is meant as a beginner's guide, with a focus on value investing. If you already understand how to value a company and why it's a bad idea to buy stock if the P/E is over 60, you might want to skip this. Otherwise...

Whenever investing gets brought up to me by non-investor, the conversation usually tends to steer towards one or both of these topics:

  • Do you think Tesla (NASDAQ:TSLA) (or 3D Systems (NYSE:DDD), Twitter (NYSE:TWTR), Groupon (NASDAQ:GRPN), Facebook (NASDAQ:FB), or whatever new company they like) is a good investment?
  • Investing is just gambling.

The first question is perfectly understandable. You would think that a company with a great product or service must be a great investment. I believe that for most people this makes a good first step in finding a company to invest in, but it would be a mistake to stop there. Say Bob is new to investing and he hears that Facebook is going to be having their IPO soon. He and everyone he knows use Facebook all the time. Even everyone on the investing forums is saying that the IPO is going to be huge. Therefore Facebook is a good investment. Bob puts all his money into the Facebook IPO and by the end of the day he doesn't know what went wrong.

Bob's conclusion is where inexperienced investors are led astray, leading to the second statement, that investing is just gambling. "Therefore [insert company here] is a good investment" is the last step in an analysis that Bob skipped almost entirely. That analysis doesn't even need to be too complicated. It could be a matter of checking if the company is making money, if the amount of money they make each year is growing, and if the price to buy into the company is fair relative to how much money they're making.

Until recently, I didn't have a good way of explaining this, until I had an epiphany at lunch over my favorite fast food entree, the Crunchwrap Supreme ("a warm, soft, flour tortilla filled with seasoned beef, warm nacho cheese sauce, a crunchy tostada shell, reduced-fat sour cream, lettuce and tomatoes and then wrapped up and grilled for maximum portability"). Yes, some very simple stock analysis is about to be explained with Taco Bell (NYSE:YUM).

Recall that at its most basic, a good stock can be identified by answering three questions:

  1. Is the company making money?
  2. Is the company making more money each year?
  3. Is the company fairly priced?

Buying a Franchise

A beneficial way to look at this is to imagine that rather than buying shares, intangible data on a computer somewhere, you're actually buying a franchise (yes, I know that you actually received pieces of paper that represented your shares at one point). For my example this is very straight forward. Whether I buy shares of YUM or buy a Taco Bell store, I'm investing in the company because I like the product and I think I can make a lot of money from it.

When someone is looking to buy a franchise, the first question they usually ask is the cost. In this case, our franchise rings up at the range of $1.2 to $2.4 million. Now let's say that from our research of comparable franchises, it can be expected to bring in earnings of $400,000 per year. Based on what you end up paying for the franchise, this gives a return on investment of 3 to 6 years. That seems fair so I buy the franchise. Lo and behold, I make my money back after 5 years and I'm happy. Everything after that is pure profit.

Let's make this more realistic and say that my Taco Bell costs $1.2 million but will only bring in $200,000 the first year. However, that profit grows by 20% every year. The first year I bring in $200,000, the second year $240,000, then $288,000, etc. After 4 years I've made back the $1.2 million. If I'm fine with this, I make the investment. I first make sure that the company has a long history of profits. Sure enough, all the Taco Bell franchises in the area have been around over 20 years and have had the same owners all that time. I talk to them and they assure me that I'm making a wise decision.

Buying Shares

If it's this simple, how do people go wrong? Like buying a franchise, you want to start with the price. I'll compare Yum! Brands to 3D Systems Corporation because of some major differences that I can highlight. As the table below shows, YUM and DDD are similarly priced at $74.39 and $75.85. By itself, this number means nothing. I cringe when I read about someone looking to buy shares with an analysis consisting of, "Down ~11% today to $120. Think it's time to buy, or will it continue to drop?"

Without knowing how much money your Taco Bell franchise is going to make, how would you be able to determine if $1.2 to $2.4 million is a good price? If it were only making $10,000 a year, you'd be insane to pay $1.2 million. Even with a 20% growth rate, it would take over 17 years to break even! Likewise, if it made $200,000 a year and consistently grew by 20% every year, but cost $100 million to own, it would take 25 years to break even. Now take into consideration that 20% consistent growth is near impossible and it will most likely even out at a much lower growth rate. Also, in that 25+ years you're likely to have a competitor or two pop up and they're going to try to take away your customers with a newer and better product. Can your Taco Bell survive if a Chipotle (NYSE:CMG) opens up shop across the street? Maybe, but you're going to have to spend more on marketing and research & development to keep or grow your bottom line.

This brings us to the stock version of the above description, price per earnings, or P/E. Yum! Brands sports a lofty 31.21 P/E, based on earnings per share, EPS, of $2.38 over the previous 4 quarters. Since YUM has a rich history of earnings, I can find the 10 year Compound Annual Growth Rate, or CAGR, and use that as my average rate of growth. For my CAGR and EPS growth calculations, I use 3 year averages to round out the effects of outliers. As the table shows, I get a 13% compound annual growth rate. Based on my $2.38 EPS and a 13% growth rate, it will take a little over 13 years to get back my initial investment. No wonder Warren Buffett sticks to Dairy Queen (NYSE:BRK.A)!

As bad as YUM seems, 3D Systems is even worse, with a P/E of 164.5! Not only that, the company has lost money in so many of the previous 10 years that I can't even calculate a 10 year growth rate, let alone 5 or 3 year. In fact, the best I can do is get a 2 year growth rate. At first glance, that 510% growth looks amazing. The reality though is that like the longer-term growth rates, it's meaningless. From 2009 to 2010, the EPS jumped by 21 times its value from $0.02 to $0.42, and then immediately dropped by 6 times its value to $0.07 in 2011. Any serious investor will tell you that the earnings are too inconsistent to make a decent 10 year CAGR prediction. In fact, I wouldn't even entertain the idea of a 2 year CAGR prediction. So what do you do with a 164.5 P/E and a virtually unknowable future growth rate in a relatively new field with lots of competition popping up every day? You look somewhere else. If you end up making a profit that can beat the S&P average it will be by sheer luck and nothing else. On the other hand, if this is your first time investing and you end up losing everything by buying into a company with a P/E of 164.5, you might just start to tell yourself that investing is no different than gambling.

Conclusion

Investing doesn't have to be gambling, though. If I presented you with the opportunity to buy a 3D printing franchise at a cost that would take you anywhere from 15 to 100 years to break even on, with no guarantee that it'll even survive that long due to all the competition, would you take me up on the offer? The answer seems more obvious when framed this way.

Note the difference between saying that the company is bad and the investment is bad. Being a value investor means that you can recognize that even though 3D printing, electric cars, social media or Doritos Locos Tacos are the future, like everything else in this world they have to be reasonably priced. The difference between investing and gambling can be as simple as asking, "but at what cost?"

Thanks for reading my article! I appreciate any feedback I receive below.

Source: Invest Like You're Buying A Franchise And Avoid Overpaying