Are You Buying Shares or a Business?

Those that bought into US electric car manufacturer Tesla [NASDAQ:TSLA] a few years ago would no doubt be patting themselves on the back.

From listing in mid-2010, the share price bounced along between $20–40 until the end of 2012. Then, as if someone flicked the ignition switch, the share price blasted upwards in 2013, hitting a high of $195. Those that bought in at $30 were quickly sitting on a 650% gain.

By 2014, the share price was heading for the $300 mark, falling just short when it peaked at around $290. Since then, it’s been a rollercoaster ride, trading between $180–280 as the traders battled it out. It looked like the short-sellers were winning earlier this year when the share price plummeted 40% in just over a month.

But then? The share price fought back, almost doubling again.

Tesla is a stock that highlights a classic battle that takes place in the market every day. The battle between what might be, and what actually is. The buyers, whether they are speculators, or investors who believe in the story, chase the stock higher.

Meanwhile, those that look at the numbers scratch their heads trying to work out what on Earth is going on. How can a company that loses money every quarter have a market-cap exceeding US$30 billion?

Surely, they think, it can’t be worth a dime. So they pile in, short-selling it some more. And yes, Tesla is one of the most shorted stocks on the globe.

Therein lies one of the great disconnects between the stock market and a private business. The market places a value on some businesses that might never turn a profit.

Take the bounce in gold from the start of this year. Lots of smaller gold stocks have doubled and tripled in price. Yet many don’t actually have a business, in the traditional sense. They might only be explorers — companies that are searching for gold, but who have yet to find a viable strike.

Or they could have found the right deposit, but haven’t secured the funding to develop it. And even if they get funding, it could be years before it goes into production. Yet the market puts a value on it, even if its future is completely unknown.

Buying a business

If you were looking to buy a business yourself, it’s unlikely that you’d look at a business that wasn’t generating revenue, let alone profit.

Of course, you might have specialist skills in technology, for example. And that could enable you to find a way to commercialise a product and get it to market. But otherwise, why would you invest? If you park your money in a term deposit instead, at least it will generate a return.

Try borrowing some money from a bank to buy a non-profitable business and see how far you get. It’s the income a business generates that ultimately determines its value. And that’s how you’ve got to look at a stock before you decide to invest.

Some might have the skills to trade in and out of the stock market to generate profits, irrespective of whether the companies they buy ever turn a profit. But eventually, a company that isn’t viable will be found out by the market.

That’s why, if you’re investing for the long term, you need to find something tangible on which to base your decision.

What to look for in a business

When a potential investor looks to buy a business, they’ll ask to look at the company’s books. That is, historical financial statements, such as tax returns, to see how the business has performed.

But what some find even more useful is the bank statements. The reason for looking at these is that it gives a simple way of seeing exactly what is coming in, and what is going out. It’s pretty hard to fudge that.

For a small business owner, what really matters is the level of cash in the bank. This gives a true picture of how their business is travelling. Of course, there are other things to establish, like debt, margins and how the sector and overall market are performing.

With share investing, one useful way to assess a company is by looking at its cash flow. Like a small business, a company with a negative cash flow might not be a good place to invest your funds.

The good thing is that you don’t need to be a full-time analyst, or pay for expensive data, to see how a company is performing. You can get it free, from many of the online brokers, such as the following from CommSec.

Telstra Financials

Telstra Company Historicals, Cash Flow and Earnings
Source: CommSec
Click to enlarge

This is just a small extract from all the data available. As you can see, it gives you a 10-year history of sales, cash flow, earnings and how much it has paid in dividends. These are annual results, but if you go to the company’s website, you’ll get half-year information as well.

What you are looking for is a company that is growing revenue, cash earnings per share (EPS), and is paying out ever increasing dividends. What you also want to check, though, is that bigger dividends aren’t coming with a higher payout ratio. That is, paying out an ever higher percentage of its after-tax profits. You can also check this from the company’s website as well.

Sometimes you’re going to miss out on some nice gains by not speculating in the latest hot stock. But equally, it might also save you from being stuck with a stock, just as the bottom falls out of the market. Buying shares based on tangible things, like cash flow and money in the bank — the way you might buy a small business — is how the professionals invest.


Matt Hibbard,
Editor, Total Income

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