There is a difference between a good company and a company’s stock that makes a good investment. How do you choose and know when a good company may be a poor investment choice? How do you keep from falling in love with a company? These are some of the tricky questions that individual stock investors wrestle with.
Here are a few things to consider when trying to identify when a good company may be a bad investment.
The Right Stock Valuation
Classic finance theory states that the valuation of a stock price over the long-term is based on the current value of its future earnings (cash flows). So, what does that even mean? It means that a company’s individual popularity unfortunately does not always translate into higher share prices. Wildly popular companies can have next to no profits. Just look at the earnings of internet companies like Facebook, Yelp, Groupon, and the like. Far too often, they are more popular than profitable.
The Amount Of Common Stock Float
There is a reason that companies buy back their shares. When a lot of common shares are floating on the open market, each shareholder’s stake is smaller than it would be if fewer shares exist. For example, if there are 100 million shares on the open market available from a company who earned $10 million in profit, each share has claims to $0.10 of that profit (10/100 mil).
If the company reduced the number of shares on the market with buybacks, each shareholder’s slice of the pie would increase. If that same company bought 20 million shares and took them off the market, each shareholder would then have 16 cents worth of the yearly profit for each share owned (10/80). That equates to a 60% increase in each shareholder’s stake in the profits.
What does this have to do with good companies and bad investments? Just take Facebook’s recent IPO as an example. In the last few days leading up to the initial sale of shares, Facebook increased the number of shares that they were issuing to a whopping 410 million from 380 million which diluted each individual shareholder’s future stake in the company by almost 10%. That doesn’t bode well for a stock that was already priced high relative to its earnings.
Stock Structure Can Affect Price
A lot of hoopla has been written about Google issuing a new class of shares of their common stock. The new shares of stock diminish shareholders’ voting rights in favor of the company’s founders. The shares have dramatically less voting rights than original shares owned by the founders which keep over 50% of control of the company solely in their hands. While this is not always a big deal to many small investors, it is something to consider when buying shares of a good company that may make it not so desirable a stock over the long-term.
What Is There Business Model?
At the end of the day, you have to understand how a company earns revenue and makes a profit. A company cannot and should not be valued solely based on how great we think it is. The company has to show tangible results to warrant higher valuations.
There are many reasons why good companies do not have successful stocks with share prices that continue to rise. It is not because they are bad companies or doing things necessarily wrong. Instead there can be a host of reason such as too many common shares on the market, poor share class structure, valuations not based on earnings, fad popularity, unclear business models, and the list just goes on and on.
I have a bad habit of falling in love with companies and brands even though at times they make for horrible stock picks. A classic example is my love for Dr. Pepper Snapple Group despite the possibility of better choices in the beverage market.
What about you? Have you ever fallen in love with a company only to be burned by their stock?