Let’s say you are given the opportunity to buy a great business. It’s a business you like. You’ve used the products and services of this business for years. You like it. You like it a lot, and now you have this opportunity to buy the business.
Realizing that your love and admiration for the company aren’t sufficient to lay out your hard-earned cash, you decide to do some very basic homework. You want to know what price you should pay for this business.
We’ll keep this (overly) simple. The business sells $1000 worth of goods and services every year. After paying all of its expenses, it earns $100. That’s the profit. As the potential investor, you are being asked to buy all of the 100 shares of stock that this company has issued. What should you pay for 1 share? At what price for a share of stock are you content earning $1.00 of profit per share? At what price for 100 shares of stock are you content earning $100 in profit each year?
Let’s start with a simple comparison. If you went to the bank and put some money in the bank at an interest rate of 2%, how much would you have to deposit in order to get $100 of interest each year? Answer: $5000 ($100 divided by 0.02)
Now, assume you have a really long-term view of life and investing. You’re going to deposit your money in something that is safe and earns a little more than you can earn at the bank. Let’s consider a 30-year Treasury bond. We’ll assume the current yield is 5%. That means, if we want to collect $100 per year of interest, we only need to deposit $2000.
Both of these are about as risk-free as you’re going to find. The business has quite a bit more risk. So, how much ”interest” or what rate of return do you want on your money if you know the business is going to provide $100 of annual profit? At 10%, you should pay $1000 for the whole business. At 20%, the $100 of annual profit says the business is worth $500. Each of the 100 shares should sell for $5.00.
Google’s revenue was $962 million and profit was $106 million in 2003. What is a share of the stock really worth? Bankers and analysts are suggesting that the business is worth $20 billion to $30 billion. The talk is that the whole company may take on a market value of $25 billion or more. In other words, to have the entire $106 million of annual profit, you would have to invest $25 billion. That makes your rate of return (the overly simplified interest rate) just a tiny bit more than 0.4%.
Remember that analysts and prognosticators are tossing around terms like price-to-sales ratios. A company with a market value of $25 billion that sells $1 billion each year has a P/S ratio of 25. IBM has a P/S ratio of 1.68.
Warren Buffett summarized his comments about the Google IPO with something like this:
”It’s a fabulous business, but my guess is that it comes at a fabulous price. We’d never buy a public offering. The chances of buying something undervalued in a public offering – it’s not our game.”Warren Buffett
Berkshire Hathaway Annual Meeting
May 1, 2004
However, some people overlooked the obvious. The same reasoning applies to the purchase of single share or 100 shares or 30,000 shares of a public company. If you’re unwilling to own all of it at the price you’re paying for one share, you’re not getting a great deal on the shares you are buying.
