Stock Forex

Choosing Stock Wisely

If there is a way to make the selection of a stock and building a portfolio of solid stocks a fun process, we’ll make every attempt to find it. A few assumptions: 1) we want to find stocks at bargain prices, and 2) we surely do not want to overpay for our stocks.

Isn’t that the essence of it all—to find great stocks at bargain prices? Also, we want to buy stock with the highest likelihood of increases in value and the lowest likelihood of losing value. If the stock produces a dividend (income) that would be nice too.

Real Estate: A Foundational Example

Determining value is very perplexing and very diffi­cult. Over the years many ways of determining value have been proposed. Whether we’re buying or selling, we want the best price. The three most common ways to determine real estate value are listed here. After this short exploration we’ll use what’s applicable from this to aid us in choosing stocks.

1)  Cost or Replacement Value

Buildings and land have value based on how it is being used. We’ll explore more of this in the income section, but we’ll cover it briefly here. A building used as a factory will be worth so much: use it for residences and it may go up in value. Turn it into a shopping center and it goes up again. You can’t do this with stock, but what the company does with its assets can change what it’s worth.

With real estate we just figure what it costs to replace the building—including the land—and that’s the replacement cost. Is it this simple? Well—not quite.

2)   Income

The gross and net income and the use of income multipli­ers are the most commonly used basis for the determination of value. You see, the cost of replacing a structure is not adequate to determine the full or accurate value.

What income does a building make? And even if you know that to the penny, other factors enter in:

A.   How long has it been since a rent increase?

B.   How expensive is the debt? And can it be refi­nanced or paid off?

C.   Can other expenses be lowered?

And none of this has to do with the tax deductions. How does it affect our tax bracket? All sorts of other variations occur. If we raise the rents, will the income remain stable? If we “net” more, the value will increase—could it be refi­nanced at a higher price and the new-found money used to buy more properties?

3)  “Comps”

One common way to value real estate is to find properties in the area which have sold recently and determine the value of your property based on an average of several properties— taking into account the differences. This is one of the func­tions of appraisers. Banks use this method extensively so they are not giving mortgages above “what the neighborhood will bear.” Extensive appraisals can be done using all three of these methods. It is wise to use all three with a more nebulous “growth potential” factor thrown in. The potential for growth or increase in value is a reason why many real estate investors invest in the first place, but so many things change, and there are so many chances to be wrong, that hardly anyone uses it as a main factor in determining current value.

I could go on, but since this is a chapter about stocks, let’s just take from real estate the thought behind the process. The example of real estate cannot solve all the problems, or answer all the questions, but it is worthwhile. It’s good to have another point of reference. I’m good at many of my stock decisions because I integrate knowledge I gained in real estate.

The point is not that many companies own real estate, but that the price of the stock, the income, and tax consequences have many similar characteristics.