Stig Brodersen, host of The Investors Podcast, joins Doug on this episode to discuss exactly what gives a stock its value. Many times people are shocked are by an expert’s valuation of a home, a car, or other personal item. The reason behind the surprise of a professional evaluation is because folks’ emotional attachment to items tend to inflate their value. Follow Stig and Doug’s discussion to learn why stocks value reflect investor expectations.
Stig offers guidance about how to take the emotional component out of stock and investment selection. He also explains why a stock’s value increases/decreases and why people are willing to pay more when a money manager is involved.
Are you ready to retire early?
Doug discusses early retirement. Even if you want to retire early, should you? And if so, what do you need to do to make sure you have enough money? He answers the last question with two suggestions to change your investing habits in order to maximize chances of financial success.
You can follow Stig Brodersen at The Investors Podcast and on twitter at @stig_brodersen
Watch How Do You Value a Stock? on YouTube.Read the Transcript
Interview With Stig Brodersen
Stig Brodersen, author and host of The Investors Podcast, shares his thoughts on investing and stock valuation.
Douglas Goldstein: I’m very happy to be talking with Stig Brodersen, who is the host of one of the top podcasts on iTunes called The Investors Podcast. Stig, how are you doing today?
Stig Brodersen: I’m great, Doug. Thanks for inviting me.
Douglas Goldstein: You talk a lot about stock investing. In fact you often talk about “stock investing 101,” which I think a lot of people sort of overlook.
They think, “I invest in stocks,” but they don’t get how complicated it is. Is it complicated for people to make money investing in stocks?
How Complicated Is It to Invest in Stocks?
Stig Brodersen: No. I don’t think it’s complicated but it’s definitely time consuming, and I think that’s probably one of the problems that we are facing as investors.
How much resource do we need to put into our stock research? That really surprises a lot of people.
Douglas Goldstein: What is the answer? How much resource do you have to put in?
Stig Brodersen: I’m glad you asked. Think about it like this first. Think about how long it takes for you to save enough money to start investing in stocks in the first place. Think about how much time it takes to find a stock.
For most people, whenever they find the stock, they say, “I go to Starbucks every day. I really like the coffee. I will go buy Starbuck stock.”
That might seem like a reasonable approach for most people, and I suggest that you invest in goods and services that you like.
Say that you want to buy a house. You would probably like to know how many square feet the house is, how many rooms, the location, a lot of different things. Whenever it comes to stock investing, it seems to be, “Well, we don’t need to know all the details. I think the stock price will go up.”
It’s important to separate the two because the key question is, how much is it worth? Doug, you probably wouldn’t buy your home if it was 10 times as expensive as it really was. No, because you’re thinking about the valuation, and it’s the same with stocks.
Douglas Goldstein: Here’s the problem with valuation. My siblings and I, and my mother are dealing with selling the house that my parents owned for about 50 years. We met with a few agents and interestingly, all the agents gave a certain price which they said the house was worth.
My siblings and I all thought it was worth about 20% more. We were laughing because that’s what we wanted it to be worth.
We can talk about stocks in a minute, but how does anyone know what the intrinsic value is of a house? You know it’s a property, but you have to look into things like the school district and the neighbors.
There are so many unknowns and so many moving parts. How can you make a decision about something that’s only one thing that you own, let alone trying to understand what the value is of some traded stock?
Understanding the Value of a Certain Stock
Stig Brodersen: You know Doug, I’m really happy you brought this example about your own home. This is the most difficult thing to value for anyone, especially if you live in the home.
Let me give you some stats here, and this was done after the crash in the U.S. after 2009. They asked many people by how much they saw real estate prices overall in the States go down.
It was by about 80%. When they got to the question, “Do you think your home has decreased in price?” when almost the entire of the United States had decreased, do you know what they said?
Two thirds of the people applying to this said, “At least the home kept its value. It might even hang on up.” There’s so much emotional attachment, I would say for your home. You grew up there, you have a lot of positive emotion, and that’s the best home in the world. Why can’t we all see that? Why are we not willing to pay 20% more for that? The problem is, unfortunately, your memories.
Douglas Goldstein: I want to challenge that. I don’t trust my memories. I know what the house is worth and I believe, and this is where you can correct me, I believe that the agents are just anxious to do a sale. As such, they’re willing to give it a price that’s 20% less in order to make it go quickly and then they can put another notch in their lipstick case and yet another house was sold.
Stig Brodersen: I think there is something to it. If you look at it generally, if people have an interest in selling something typically by commission, they would typically say a lower price because the turnover, the time it takes to turn over the home, is very expensive for the agent.
If you would like a good answer to how much your home is worth, you should go ask your neighbors. Studies show that the neighbors, in general, are good at valuing your home; because they’re a lot more objective about it and they also know a lot more about the neighborhood.
Douglas Goldstein: Interesting. We’re talking with Stig Brodersen, who is in fact very interesting; you can hear him on The Investors Podcast, which is rated number one in the stock investing categories on iTunes. Interesting, Stig, you’re saying to ask your neighbor. Let’s relate that for example to the stock market, where you’re going to ask people who may not have an interest in a particular stock, for example: stock analysts.
I’m not talking about stock analysts who would have an interest. Maybe they work for an investment bank, and so therefore they might give a company a very high rating in order to, on the other side of the table, win the investment banking business, but a stock analyst who maybe is an independent, or an independent money manager or fund manager, whose only goal is to make money for himself and his clients because let’s say he earns a percentage of the profits or percentage of the value of the portfolio. Why is there a problem? Why is there a problem asking someone like that to help you to value a stock, and figure out when it’s trading below its true value so you could buy it?
The Challenge of Asking a Money Manager to Value a Stock for You
Stig Brodersen: Well, there doesn’t have to be a problem. Very often, though, there is a problem because it’s very difficult to make those interests align, of the advisor and the client. Most advisors would be compensated, as you suggest, Doug, as a percentage, which means that the advisor would also have an incentive to pick very volatile stock for the sake of being volatile. Because since they’re getting a cut of how much it would go up, why not take a stock that fluctuates a lot? That’s something that we see very often.
Douglas Goldstein: Why are you saying that’s a bad idea?
Stig Brodersen: Very often, the client would have to pay the downside while they have to share the upside.
Douglas Goldstein: That’s maybe referring to a hedge fund. Hedge funds will often take a percentage of the profits and they might even have a high watermark, which means until they achieve that level again, they don’t get a percentage of the profits.
Let’s talk about, for example, a mutual fund or a managed account where the money manager is simply getting a percentage of the value of the portfolio.
The only way for the managers to increase their income is to increase the size of their portfolio, and the client’s portfolio and that’s a decent incentive for them to buy extra volatiles stocks because if they crush the client, then their income gets crushed and the client leaves.
Stig Brodersen: I’m not sure I agree with that, and I’m really happy we’re having this discussion, because we learn the most whenever we have disagreements.
I can see your argument. Yes, there will be a lot of reasons for them not to pivot on stocks, and it’s true. Very often, let me take very stable stocks, and there is this old saying on Wall Street, “You can never get fired by taking IBM.” What happens, for a lot of these big mutual funds, is that they spend a lot of the money than the clients have on marketing, because they are compensated on the performance, but actually two thirds on average of the revenue that they’re achieving, that’s from the expense ratio.
That is from the fees they’re charging for the money they’re managing. That’s also why you see that a lot of these funds are very expensive and all the money is spent on marketing.
Douglas Goldstein: Okay, so let’s go back to what you said before. You were saying we should ask our neighbors what the value of our houses might be, and then I tried to turn that around to a question of, so who should you ask about the value of the stock. Who should you ask about the value of the stock?
Who Should You Ask About the Value of a Stock?
Stig Brodersen: The simplest thing for me to say is, you need to calculate it yourself. You need to find the person who you really trust and who has the same investors’ regime like you. At the end of the day, the value of the stock, that is what is called the discount in cash flow of that… At the end of the day the value of a business is how much money it generates.
I know I make it sound simple, but that’s basically it. Let me give you a quick rule of thumb. On average, in the U.S., a stock would be trading somewhere around 15 to 17 times earnings.
On average, you’ll be spending $15 to $17 for $1 of earnings or what changes later to around 6.6% in return.
Douglas Goldstein: Let’s go into this. Off the cuff you said, 15 to 17 times earnings is a normal PE, which is a little bit below what the S&P 500 is for now. I’m not sure that’s the right index to look at in any case. Why is that the normal? Why shouldn’t it be 5 times earnings or 25 times earnings?
Stig Brodersen: That’sa great question. If you asked the academics, they would say, “Well, that is how much risk, or that is the return that investors will require for the amount of risk that they’re taking on, by investing in that SA class. We can more or less see that the GDP growth, for instance, like the United States, follows the stock market and then there is a, what we call a risk premium by investing in stocks.
Douglas Goldstein: What you’re saying is that people are willing to pay more than a risk-free asset in order to try to make more money, let’s say compared to bank deposits for Treasury bonds?
Stig Brodersen: Yes, that’s correct because it’s perceived to be a higher risk. Also, because as we talked about, stocks would be more volatile and people could lose the money a lot faster.
Douglas Goldstein: You can also end up with a possibility of a hard mentality, meaning that, if someone is willing to pay 14 times earnings for a stock, and then he says, “Well, maybe it looks pretty good, I’ll pay 15 or 16 or 17 times earnings,” all of a sudden he’s paid a lot more for that stock, than when it was at 14 times earnings.
I think the problem, and it goes back all the way to the beginning of what we were saying, is how people make decisions emotionally. It was based on the house that we’re looking to sell.
It feels to me like it’s worth more but that’s not what the true market value is. I guess that’s where people have to be really concerned.
Stig Brodersen: Yeah, it’s a great point and you see high stocks like Amazon and Tesla, I mean more or less than not, making any kind of money. The reason why people are willing to pay a lot of money for the stock is that they expect growth. Now I’m not here to say that Amazon would be a bad stock or Tesla would be a bad stock, but the companies need to grow a lot and they need to make a lot of money before they can justify the evaluation.
That’s why just like a really quick rule of thumb, if you need to invest in stocks, or if you would like to value stocks, look at how much money they’re making and don’t pay more than 10 or 12 times the earnings.
Douglas Goldstein: Interesting. Stig, that’s some good advice you’ve given us, and some real insight about how to look at stocks. Unfortunately, we’re just about out of time, so tell me in the last few seconds, how can people follow you and follow your work?
Stig Brodersen: They can tune in to theinvestorspodcast.com where we study billionaires and financial markets, so please check it out.
Douglas Goldstein: Okay, we’ll put a link to that at today’s show notes. Thanks very much, Stig Brodersen.
Stig Brodersen: Thank you, Doug.