The BIG MISTAKE Business schools teach their students to make every day
Drizzt’s Take:
I like this article by Dr Paul Price, which i find it true to the certain extent. The disappointing thing is that, he didnt delve deeper into why on a same fundamental structure does a company’s share price gyrate to that extent. Nevertheless, it is an interesting article. Folks can tune in to this topic’s discussion here.
by Dr Paul Price
I occasional lecture at business schools in my area and I’m always amazed at the way finance departments teach their students to value company shares. These professors are very adept at noting many statistical measurements of the corporations’ performance such as:
* Operating Margins
* Net Profits
* Income Tax Rate
* Net Profit Margins
* Working Capital
* Long and Short Term Debt
* Debt/Equity
* Shareholder Equity
* Return on Equity
* Return on Assets
* Return on Total Capital
* Average Weighted Cost of Capital
* Payout Ratio
* Stock Price Beta
* Book Value
Students are taught to evaluate the above items to determine if stocks should be bought or sold. All of the data listed above are real and can be useful in deciding whether or not you might be interested in owning a company’s shares. Why, then, do I criticize the use of those things in making buy, sell or hold decisions?
NONE of the above statistics vary one bit depending on the fluctuations in share price.
If a stock goes from $20 to $80 the measurements listed above will not change one bit [except maybe its Beta]. When something is a constant regardless of share price movement it should be ignored in decisions concerning future price movement of the stock. This is also true in discussions of the attractiveness of the business the company conducts. Unless a company has made a material change in what product or service they provide then that too, is a constant.
Here are the fluctuations seen in some well known company shares that have not experienced any radical changes in their business models in recent years:
| Company | High – [year] | Low | High | Low |
|---|---|---|---|---|
| McDonalds (MCD) | $49.60 – 1999 | $12.30 – 2003 | $31.70-2006 | $57.53 – 2007 |
|
Berkshire Hathaway |
$84,000 – 1998 | $40,800 – 2000 | $78,800 – 2005 | $128,300 – 2007 |
| GE (GE) | $60.50 – 2000 | $21.30 – 2003 | $32.10 – 2006 | $42.15 – 2007 |
| IBM (IBM) | $71.90 – 2005 | $97.90 – 2006 | $88.80 – 2007 | $121.46 – 2007 |
| Hershey (HSY) | $67.40 – 2005 | $48.20 – 2006 | $56.80 – 2007 | $44.01 – 2007 |
All the shares experienced great volatility in share price while the basic business models were constants. Consequently, your like or dislike of their basic product or service should never have been a factor in predicting their share price movements.
What then should be considered in assessing the buy-hold-sell decision on an individual stock?
Things I find most useful in selection of undervalued stocks:
* P/E lower than that same issue’s normalized P/E.
* Not lower than the industry P/E or the ‘market’ P/E.
* Price/Cash Flow lower than that same stock’s normalized P/CF.
* Price/Book Value lower than that same company’s P/BV.
* Dividend Yield higher than that same firm’s typical payout. [if applicable]
All the above criteria vary directly with changes in share price and thus are extremely useful in predicting future share price direction.
Related posts:
- Mint.com Launches Finance Game to Teach Kids–Should Singapore Schools do the same?
- 4 fiscal lessons to teach your kids
- I made a grave mistake.
- Seth Klarman’s 3 Method for valuing a business
- Your not so normal business cards
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