run around in acircle chasing a little mechanical rabbit. It’s fun to watch,and you get to hang out with some really great people.Some of them even have teeth!You know what, though—on second thought, maybethat’s not such a good idea, either. I kind of figured itwasn’t for me after my dog actually caught the rabbit. Mylittle guy got trampled by the other dogs on the first turn,
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[17]
got up, and started running the wrong way. Unfortunately, the mechanical rabbit zips around the track atabout 60 miles an hour, and when my dog, the one I hadplaced my faith in and my money on, took a flying leap atthe rabbit speeding toward him . . . let’s just say it wasn’tpretty (all right, since you’re probably concerned—thedog slammed into the 60-mile-per-hour rabbit at fullspeed, flew 30 feet in the air, and was tragically disqualified, which meant, alas, I had lost all of my money).*In any case, now that we’ve explored most of the logical alternatives for your money (though I’m sure theyrace worms and various crustaceans some place I haven’tfound yet), let’s look at one more. How about investing ina business? After all, Jason’s going to grow up someday.Maybe he’ll open up his own gum store. Better yet, maybehe’ll open up a whole bunch of gum stores (usuallyreferred to as a “chain” of stores) under some catchyname like Jason’s Gum Shops.Let’s assume that Jason personally trains all the salespeople in his unique brand of gum selling and that thechain is wildly successful (it could happen). Now Jasoncomes to you willing to sell half his business (he wants tobuy a new pair of sunglasses, a real limousine, and maybea house for himself and the lucky Mrs. Jason). Only now*And yes, the dog was fine.
[18]
J O E L G R E E N B LAT T
he’s asking for big bucks, and we’ll have to do some serious figuring before we can decide whether to take Jasonup on his offer.It turns out that Jason’s grown up quite a bit since thedays when he scootered himself around town, and he nowwants a hefty $6 million for half ownership of his business.Of course, 6 million bucks is more than most of us canafford, but, luckily, Jason isn’t looking to sell half ownership of his business all to one person. In fact, Jason hasdecided to divide ownership of his business into a millionequal pieces, or shares (as they’re referred to on WallStreet). Jason’s plan is to keep 500,000 shares for himselfand sell his other 500,000 shares for $12 apiece, or $6million in total. Anyone interested in buying part ofJason’s business at that price can buy one share (for $12),a hundred shares (for $1,200), a thousand shares (for$12,000), or pretty much any number of shares they want.If you were to buy, for example, 10,000 shares costing$120,000, you would then own 1 percent of Jason’s GumShops (10,000 shares divided by the 1-million-share total).That 1 percent doesn’t mean that you would own thespearmint gum department or a small piece of one ofJason’s stores. Your 10,000 shares, or 1 percent ownership, of Jason’s Gum Shops means that you would be entitled to 1 percent of the future earnings of the entireJason’s Gum Shops business. Now, of course, all you
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[19]
would have to do is figure out whether paying $120,000 for1 percent of Jason’s future gum profits is a good deal.(This is where our analysis gets a little sticky; we have tobe good gumshoes so we don’t blow it and have our moneychewed up and spit out. . . . Anyway, you get the idea.)Luckily, Jason has provided us with a lot of information. Since we already know that Jason wants $12 for eachshare in Jason’s Gum Shops and that there are 1 millionshares in total (this is referred to as 1 million shares outstanding), this means that Jason thinks his business isworth $12 million (and therefore he thinks that 1 percentof his business is worth the $120,000 we just talkedabout). Well, that’s all fine and dandy, but what mattershere is what we think it’s worth. So let’s take a look atsome of the other information Jason has given us.It seems that last year Jason sold a total of $10 millionworth of gum from the 10 stores in the highly successfulJason’s Gum Shops chain. Of course, the $10 million ishow much gum Jason’s stores sold, but unfortunately, $10million isn’t how much profit Jason made. Obviously,Jason’s stores ran up a few expenses along the way. Naturally, there was the cost of the gum that Jason sold—thattotaled $6 million. That left him with $4 million in profits. But wait, we’re far from finished.There was the rent Jason had to pay for the use of his10 store locations; then there were those pesky employees
[20]
J O E L G R E E N B LAT T
who for some reason expected to get paid for selling gumand keeping the stores clean and running smoothly; therewere electricity and heating costs, trash removal, andaccounting and all kinds of administrative costs (so Jasoncould keep track of all the money and gum flying all overthe place)—and that stuff adds up. In this case, another $2million in expenses to be exact. That got Jason’s businessdown to $2 million in profits. But as you suspected, we’renot done yet.Jason’s business had to pay taxes. The governmentneeds money to provide services to its citizens, and profitable businesses must pay their share of taxes to keep itgoing. In the case of Jason’s Gum Shops, that tax is equalto 40 percent of income (a fairly standard rate for manybusinesses). So 40 percent of the $2 million in profits thatJason’s gum business earned last year had to go to thegovernment in the form of taxes. Since 40 percent of $2million is $800,000, that left Jason’s Gum Shops with anet profit of $1.2 million.Actually, Jason provided us with all that informationabout last year’s income in a very neat table, known as anincome statement (see Table 3.1).So there you have it. Jason’s Gum Shops earned $1.2million last year. Jason thinks that makes the businessworth a total of $12 million. He is willing to sell us a pieceof that business, in any size up to half the entire business,
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[21]
TABLE 3.1 Jason’s Gum Shops Annual Income Statement(For the Last 12 Months)Total sales
$10,000,000
Cost of goods sold(i.e., the gum)Gross profit
−6,000,0004,000,000
Selling, general, &administrative expenses
−2,000,000
Income before taxes
2,000,000
Taxes (@40%)
−800,000
Net income
$1,200,000
at that $12 million valuation (i.e., $6 million for half, $1.2million for a 10 percent stake, $120,000 for 1 percentownership, and one share equaling one-millionth of thebusiness for a measly $12). Should we do it? To keep itsimple, let’s take a look at what we’ll be getting for each$12 share.Well, Jason has divided his business into 1 millionequal shares. That means, if the whole business earned$1,200,000, each share earned one-millionth of thatamount. Since $1,200,000 divided by 1,000,000 is $1.20,each $12 share was entitled to $1.20 in earnings. Is that a
[22]
J O E L G R E E N B LAT T
good deal? Let’s look at it this way. If we invest $12 for apiece of Jason’s business and it earns us $1.20 in the firstyear, our first-year return on our investment would be$1.20/$12, or 10%A 10 percent return in our first year! Pretty darngood, right? In Chapter 2 we discussed that, at the veryleast, we had to beat the 6 percent annual return from a10-year U.S. government bond. That’s because buyingthose bonds would earn us 6 percent without having totake any risk. Since earning 10 percent is clearly morethan earning 6 percent, ipso fatso, is it then true that paying $12 for a share that earns $1.20 a good deal?Well, life isn’t quite that simple (but as we’ll see in alater chapter, almost!). The bottom line is—we’re off to agreat start, but we have to consider a few more thingsbefore we can make up our mind.First, $1.20 per share is what Jason’s Gum Shopsearned last year. We have to determine whether we thinkthe business will earn that $1.20 in the coming year—ormore than that—or maybe less. Last year’s earnings may bea good starting point for estimating next year’s earnings,but it may not. If Jason’s Gum Shops doesn’t earn $1.20next year, the business won’t be earning that 10 percent
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[23]
we expected on the $12 per share we just paid—it could behigher—but it could be lower.Second, once we come up with our estimate for howmuch Jason’s business will earn next year, we have todetermine how confident we are in our prediction. If we’retaking a wild guess because we have no idea whether gumsales are steady from year to year, whether Jason’s gumstores are just a fad, or whether new competition fromother candy stores will affect Jason’s profits, then ourestimate may be suspect. But we have to be reasonable. Ifwe’re not sure whether earnings will be $1.50 or $2.00per share, that kind of uncertainty is fine. Both of thosenumbers will represent that Jason’s business is earningmore than that 10 percent on our initial $12-per-sharecost. On the other hand, if we’re uncertain whether theearnings will be 20 cents per share or $1.20, then ourguaranteed 6 percent from the government bond maystart to look a whole lot better.The third little detail we haven’t yet considered is thatnext year is only one year. Even if Jason’s Gum Shopsearns $1.20 next year (or a lot more or a lot less), whatabout all the years after that? Will earnings keep growingevery year? Maybe each store will keep selling more gumeach year, and earnings will increase that way. Or maybeif 10 stores can make $1.20 per share, getting to 20 stores
[24]
J O E L G R E E N B LAT T
in a few years will cause earnings to grow to $2.40 pershare or even higher? Of course, the gum business couldalways turn sour (sorry) in the next few years, causinggum earnings to remain stuck at levels well below $1.20for a long time. And there’s more . . .Okay, you’re beginning to panic. I can feel it. Thisstuff is too hard. How are you going to figure it all out?How can anyone? And even if you take your best shot, amI expecting you (and my kids, for that matter) to “gamble”real money on a pile of guesses and estimates? And, ohyeah, aren’t there tons of MBAs, PhDs, smart financialtypes, and professional investment analysts, not to mention full-time money managers, trying to figure out prettymuch the same things? How can little old you competewith all those hardworking, smart, sophisticated guys?All right already, enough, calm down. Sheesh, can’t Itake you anywhere? Have a little faith. Hang in there. I’lldo that summary thing, tell you what’s important toremember, and we’ll move on. Man, if I have to hold yourhand for every little thing . . .So, here’s what you need to know:1. Buying a share in a business means you are purchasing a portion (or percentage interest) of thatbusiness. You are then entitled to a portion of thatbusiness’s future earnings.
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[25]
2. Figuring out what a business is worth involves estimating (okay, guessing) how much the business willearn in the future.3. The earnings from your share of the profits mustgive you more money than you would receive byplacing that same amount of money in a risk-free10-year U.S. government bond. (Remember: Lastchapter we set 6 percent as your absolute minimumannual return when government bond rates fallbelow 6 percent) and4. No, I haven’t forgotten about the magic formula.But you’re going to have to stop bugging me aboutit, okay? Sheesh!
Chapter Four
GREAT, FIGURING OUT WHAT A BUSINESS is worth isn’t easy.After lots of guessing and estimating, maybe you get itright and maybe you get it wrong. But what if you could?What if you could figure out what a business was reallyworth? Is there something you could do with that information? Is there really a place like I promised in the firstchapter, a place where you can buy a business for half itstrue value? A place where you can get $1,000 of value foronly $500? You bet there is. But first, let’s spend a fewminutes in business school.For the past nine years, I have taught an investingcourse to a group of graduate business students at an IvyLeague university. Needless to say, this is a pretty smart
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[27]
group of students. Each year, on the first day of class, Iwalk in and open the newspaper to the financial section.Found there are pages and pages of tables with lots ofnumbers in tiny print. (Sounds great so far, right?) Anyway, posted in these tables is a list of company names, andnext to each name is a bunch of prices.“Call out the name of a big, well-known company,” Isay. The students come up with companies like GeneralElectric, IBM, General Motors, and Abercrombie &Fitch. Actually, it doesn’t really matter what companiesthe students shout out. My main point is so easy tomake, any company name in almost any industry, large orsmall, well-known or not, will do. The result is alwaysthe same.I look in the paper next to General Electric and readoff the numbers. “It says here that the price for one shareof General Electric was $35 yesterday. It also says herethat the highest price that General Electric shares havesold for over the last year was $53 per share. The lowestprice for a share over the last year was $29.“For IBM, it’s the same thing. You could have purchased one share of IBM yesterday for $85. Over the pastyear, shares of IBM have sold for as much as $93 and foras little as $55.“General Motors sold for $37 per share yesterday.But over the last year, shares have sold for between $30
[28]
J O E L G R E E N B LAT T
and $68. For Abercrombie & Fitch, which was selling for$27 per share yesterday, the range of prices per share overthe last year has been between $15 per share at the lowestand just over $33 per share for a high price.”I then point out that that’s a pretty wide range of pricesfor shares and a pretty short period of time for them tochange so much. Looking at the price for shares over a twoto three-year period would give us an even wider range.So here’s the question that I always ask: How can thisbe? These are big, well-known companies. Each of thesecompanies has divided its ownership into millions (andsometimes billions) of equal shares, just like Jason didwith his gum shops. Initially, companies sell their sharesto the public (to both individuals and big institutionalinvestors). After that, though, the people who buy theseshares are free to sell them to anyone they want.Each day the newspaper lists the names of thousandsof companies and the price at which people have beenbuying and selling an ownership share in each. The trading back and forth of these ownership shares takes placein a number of locations and over computer networks.These ownership shares are referred to as shares of stock,and collectively, this buying and selling activity is referredto as the stock market.A company as large as IBM or General Motors mighthave divided its ownership stake into something like a
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[29]
billion equal shares. That means that if at one point during the year you can purchase one share of GeneralMotors for $30 (and for our example we assume the ownership of General Motors has been divided into 1 billionequal pieces, or shares), then the implied price to purchase the entire company (all 1 billion shares) would be$30 billion. However, if at some point during the sameyear, General Motors shares could have been purchasedfor $60 each, that would indicate that the cost to purchaseall of General Motors would be $60 billion.So I ask the question again: How can this be? Can thevalue of General Motors, the largest car manufacturer inNorth America, change that much within the same year?Can a company that large be worth $30 billion one dayand then a few months later be worth $60 billion? Arethey selling twice as many cars, making twice as muchmoney, or doing something drastically different in theirbusiness to justify such a large change in value? Ofcourse, it’s possible. But what about the big price changesin IBM, Abercrombie & Fitch, and General Electric?Does something happen each and every year to accountfor large changes in the value of most companies?Remember, every year the results are the same. Forpretty much any company that my students name, therange of high and low prices, over the course of only oneyear, is huge. Does this make sense? Well, to save the
[30]
J O E L G R E E N B LAT T
class time (and since my attention span is usually a matterof seconds), I usually blurt out the answer. No! It makesno sense that the values of most companies swing wildlyfrom high to low, or low to high, during the course ofeach and every year. On the other hand, it seems prettyclear that the prices of the shares in most companies swingaround wildly each and every year. All you have to do islook in the newspaper to see that that’s true.So I ask my room full of smart, sophisticated students to try to explain why. Why do the prices of all thesebusinesses move around so much each year if the valuesof their businesses can’t possibly change that much?Well, it’s a good question, so I generally let my studentsspend some time offering up complicated explanationsand theories.In fact, it’s such a good question that professorshave developed whole fields of economic, mathematical,and social study to try to explain it. Even more incredible, most of this academic work has involved coming upwith theories as to why something that clearly makes nosense, actually makes sense. You have to be really smartto do that.So why do share prices move around so much everyyear when it seems clear that the values of the underlyingbusinesses do not? Well, here’s how I explain it to mystudents: Who knows and who cares?
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[31]
Maybe people go nuts a lot. Maybe it’s hard to predict future earnings. Maybe it’s hard to decide what a fairrate of return on your purchase price is. Maybe peopleget a little depressed sometimes and don’t want to pay alot for stuff. Maybe people get excited sometimes and arewilling to pay a lot. So maybe people simply justify highprices by making high estimates for future earnings whenthey are happy and justify low prices by making low estimates when they are sad.But like I said, maybe people just go nuts a lot (stillmy favorite). The truth is that I don’t really have to knowwhy people are willing to buy and sell shares of most companies at wildly different prices over very short periods oftime. I just have to know that they do! Why is this helpful?Let’s think about that.Suppose you figured that a business (perhaps one likeJason’s Gum Shops) was worth between $10 and $12 pershare, and at varying times during the year, its sharescould be purchased for between $6 and $11. Well, if youwere confident about your estimate of what the businesswas worth, then deciding whether to buy shares when theywere trading near $11 might be a difficult decision. Butwhen shares in that same company during that same yearwere available at close to $6, your decision might wellbecome much easier! At $6 per share, if your estimates ofvalue were close to correct, then you would be buying
[32]
J O E L G R E E N B LAT T
shares in Jason’s Gum Shops for only 50 or 60 cents onthe dollar (for 50 or 60 percent of what they were trulyworth).One of the greatest stock market writers andthinkers, Benjamin Graham, put it this way. Imagine thatyou are partners in the ownership of a business with acrazy guy named Mr. Market. Mr. Market is subject towild mood swings. Each day he offers to buy your shareof the business or sell you his share of the business at aparticular price. Mr. Market always leaves the decisioncompletely to you, and every day you have three choices.You can sell your shares to Mr. Market at his statedprice, you can buy Mr. Market’s shares at that sameprice, or you can do nothing.Sometimes Mr. Market is in such a good mood thathe names a price that is much higher than the true worthof the business. On those days, it would probably makesense for you to sell Mr. Market your share of the business. On other days, he is in such a poor mood that henames a very low price for the business. On those days,you might want to take advantage of Mr. Market’s crazyoffer to sell you shares at such a low price and to buy Mr.Market’s share of the business. If the price named by Mr.Market is neither very high nor extraordinarily low relative to the value of the business, you might very logicallychoose to do nothing.
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[33]
In the world of the stock market, that’s exactly how itworks. The stock market is Mr. Market! If, according tothe daily newspaper, General Motors is selling for $37 pershare, you have three choices: You can buy shares in General Motors for $37 each, you can sell your shares in General Motors and receive $37 each, or you can do nothing.If you think GM is really worth $70 per share, then youmight consider $37 a ridiculously low price and decide tobuy some shares. If you think GM is really worth only $30or $35 per share (and you happen to own some shares),you might decide to sell to “Mr. Market” at $37. If youthink each share of General Motors is worth between $40and $45 per share, you may decide to do nothing. At $37per share, the price is not at a big enough discount for youto buy, nor is $37 a generous enough offer to make youwant to sell.In short, you are never required to act. You alone canchoose to act only when the price offered by Mr. Marketappears very low (when you might decide to buy someshares) or extremely high (when you might consider selling any shares you own to Mr. Market).Graham referred to this practice of buying shares of acompany only when they trade at a large discount to truevalue as investing with a margin of safety. The differencebetween your estimated value per share of, say, $70 andthe purchase price of your shares of perhaps $37 would
[34]
J O E L G R E E N B LAT T
represent a margin of safety for your investment. If youroriginal calculations of the value of shares in a companylike General Motors were too high or the car businessunexpectedly took a turn for the worse after your purchase, the margin of safety in your original purchase pricecould still protect you from losing money.Even if you originally estimated fair value to be $70,and it turned out that $60 or even $50 was closer to thetrue value for each share, a purchase price of $37 wouldleave enough margin for you to still make money on youroriginal investment! Graham figured that always using themargin of safety principle when deciding whether to purchase shares of a business from a crazy partner like Mr.Market was the secret to making safe and reliable investment profits. In fact, these two concepts—requiring amargin of safety for your investment purchases and viewing the stock market as if it were a partner like Mr. Market—have been used with much success by some of thegreatest investors of all time.But wait! There’s still a problem here. Okay, maybe afew. First, as we discussed, how are you supposed to knowwhat a business is worth? If you can’t place a fair value ona company, then you can’t divide that number by the number of shares that exist, and you can’t figure out what thefair value of a share of stock is. So even if a share of General Motors sells for $30 on one day and $60 per share a
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[35]
few months later, you have no idea whether one of thoseprices is cheap and one is expensive or both are cheap orboth expensive, or whatever! In short, from what we’velearned so far, you wouldn’t know a bargain price if it hityou in the head!Second, if you could figure out a fair price or pricerange for the business, how would you know whether youwere right, or even close to right? Remember, in theprocess of figuring out the value of a business, all you dois make a bunch of guesses and estimates. Those estimates involve predicting earnings for a business for manyyears into the future. Even experts (whatever that means)have a tough time doing that.Third, as we already covered, aren’t there tons ofsmart, hardworking people trying to figure out all thisstuff, too? Aren’t there lots of stock market analysts andprofessional investors who spend their time trying to figure out what companies are really worth? Even if I couldreally teach you how to invest, wouldn’t these smart,knowledgeable, and experienced people be better at itthan you? Wouldn’t these people scoop up all of the obvious bargains before you got there? How can you competewith those guys? All you did was buy a book—a book thatsays even kids (okay, teenagers) can learn how to make bigmoney in the stock market. Does that make sense? Whatchance do you really have?
[36]
J O E L G R E E N B LAT T
Well, a sane person might start to feel a little foolishabout now. But you paid good money for this book! Youcould already be a few cards short of a full deck. So atleast we’ve got that going for us! In any case, ready ornot, here comes the summary:1. Stock prices move around wildly over very shortperiods of time. This does not mean that the valuesof the underlying companies have changed verymuch during that same period. In effect, the stockmarket acts very much like a crazy guy named Mr.Market.2. It is a good idea to buy shares of a company at a bigdiscount to your estimated value of those shares.Buying shares at a large discount to value will provide you with a large margin of safety and lead tosafe and consistently profitable investments.3. From what we’ve learned so far, you wouldn’t knowa bargain-priced stock if it hit you in the head.4. Being a few cards short of a full deck, you might aswell keep reading.
Chapter Five
I LOVE MOVIES, and The Karate Kid is one of my favorites.Of course, I would like any art form where eating popcornand candy are part of the deal. But there is one scene inthis particular movie that holds special meaning for me. Init, the old karate master, Mr. Miyagi, is supposed to beteaching his teenage apprentice, Daniel, how to fight.The boy is new at school and being bullied by a group ofkarate-trained toughs. Daniel hopes learning karate willhelp him stand up to his tormentors and win the girl of hisdreams. But instead of teaching him karate, Mr. Miyagiputs Daniel to work—waxing cars, painting fences, andsanding floors.
[38]
J O E L G R E E N B LAT T
So after a whirlwind of scenes showing poor Danielworking his fingers to the bone—waxing, painting, andsanding—the youth has finally had enough. He confrontsMr. Miyagi and essentially says, “Why am I wasting mytime doing these simple and menial tasks when I should belearning karate?” Mr. Miyagi has Daniel stand up from hissanding duties and starts throwing jabs at the young boywhile yelling “Wax on! Wax off!” Daniel deflects each jabwith the swirling motions he learned from so many hourswaxing cars. Next, Mr. Miyagi throws a punch whileyelling “Paint the fence.” Once again, Daniel deflects thepunch, this time using the up-and-down action of paintinga fence. Similarly, Mr. Miyagi’s karate kick is then stoppedby Daniel’s expert floor-sanding ability.In effect, by learning these few simple techniques,Daniel has unwittingly become a karate master. Now ingood movies, the viewer participates in something calledthe willing suspension of disbelief. In other words, we kind ofknow that Ralph Macchio, the actor who plays Daniel inthe movie, couldn’t really use that waxing thing to defendhimself in a dark alley. In the real world, before he couldfinish his first coat, Mr. Macchio would probably getsmacked in the head and drop like a sack of potatoes. Butwhile caught up in a movie, we’re ready and more thanwilling to believe that Mr. Miyagi’s simple methods cantruly work wonders.
T H E L I T T L E B O O K T H AT B E ATS T H E M A R K E T
[39]
Well, I’m going to have to ask you to do a little suspending of disbelief, too. Not because what you’re goingto learn doesn’t make sense. On the contrary, the twoconcepts in this chapter are simple and obvious. It’s justthat these two concepts are so very basic, you’ll have ahard time believing that such simple tools can turn youinto a stock market master. But pay close attention now,and I promise you won’t get a smack in the head later.When we last left Jason, the hero of our story, he hadjust asked us to chew over an exciting proposal. His proposal was simple: Would we want to buy a piece of hiswildly successful chain of gum stores, Jason’s Gum Shops?(You want some, you know you want some . . .) But asmuch as Jason wanted to sell us a piece of his business, giving him an answer wasn’t turning out to be so simple.By looking at the income statement that Jason had provided us, it turned out that Jason’s chain of 10 gum shopshad earned a total of $1.2 million last year—pretty impressive. Since Jason had divided his business into 1 millionequal shares, we had