A Rose is a Rose

A Rose is a Rose

What makes a stock expensive?

It’s a truism to say that the way to make money in the market is to buy low and sell high. What goes into a stock price to make it cheap or expensive? It isn’t the dollar price: Apple shares at $600 are generally considered to be cheaper than Facebook shares at $20. That’s because Apple earned $42 / share over the past year, has $30 of cash / share on hand, and plans to pay over $10 / share in dividends over the next year. By contrast, Facebook earned 18 cents, and has $4.76 per share of cash, and has no plans for a dividend.

So Facebook is valued at 115 times earnings, while Apple is 15 times. Does that make Apple cheap?

Not necessarily. There’s also the issue of growth. The reason most people own stocks is so that their portfolios can grow over time. That’s why we endure the risk of owning the most junior claim on a company’s cashflow: that junior claim is entitled to the residual growth. But if there’s little room for growth, there’s little reason to pay a multiple of 15 times or even 10 times. A company in decline may be unsafe at any price.

A case in point may be Dell Computers. This darling of the past made scores of people rich, as its annual growth rate during the ‘90’s was almost 100% / year. $1000 invested in Dell in 1990 grew to an improbable $1 million by the end of the decade.

But time–and markets–seem to have left Dell in the woods. The shares have fallen 80% since then, as first internal problems and then the tablet revolution seem to have passed Dell by. The stock, which once sold for 150 times earnings, now goes for 7 times. And even that may be too much, if management can’t find a way to turn the company around.

Over the long run, the stock market is a weighing machine, evaluating earnings, growth, and management. Just because the share prices have gone up doesn’t make them expensive. And just because they come down doesn’t make them cheap.

Follow me on Twitter @tengdin

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