How Do You Know When To Buy And Sell a Stock?

As quote in the book of Buffettology, "Warren has defined the intrinsic value of a business as the sum of all the business's future earning discounted to present value."

The answer is to calculate the intrinsic value of the company, or how much does the company exactly worth minus off all the hype from the market.

Why is calculating the intrinsic value of a company stock important? With the intrinsic value, you can determine when is the right time to enter into a market. And with the intrinsic value, you can determine when to sell off the stock.

Let us an example of a company A stock to illustrate the point.

If earning per share for a Company A is $2.21 a share. And that the government bonds is 7%, then the value of the share relative to bond is ($2.21 / 0.07) = $35.71, which mean that if you paid $35.71 for Company A share, you would be getting a return equal to that of the government bond. If you paid $54 per share for Company A share, then your initial rate of return would be ($2.21 / $54) = 0.041.

Let assume you paid $54 per share for Company A share (this is what the company share is trading in the market now ) and paid another $54 to buy government bonds, which will give you a better return at the end of 10 years? Let's investigate:

So you may think that it is better to invest in goverment bond giving 7% rate of return than Company A stock giving 4.1% rate of return. However, you are wrong!

Government bond is not able to compound for your advantage while Company A share could. If company A share per share earning growth rate is 14%, then in 10 years time, it would have a per share earning of $8.20. If the average P/E ratio of Company A share is around 17, then we can project that the market price for company A share ten years later is ($8.20 * 17) = $139.4. The compound rate of return will be around 9.8%. Take out your PV Calculator, punching $54 as PV and $139.4 as FV, and 10 for the number of years, you would get 9.8%.

As compare to $54 invested in governemt bonds, every year you will receive interest of $3.78. For the next ten years, you will received a total interest of $37.8 which give you a total return (plus your initial investment) of $91.8. The rate of return for the government bond would be 5.7%.

So in the above case, which one will you choose?

In reference to Mary Buffett in the book Buffettology, the compound rate of return is what Warren Buffett use for estimating whether a stock is overprice or not. He normally look out for company that can generate a compound rate of return of greater than 15%.

However, to be more accurate, you should calculate the intrinic value of the stock. To calculate the intrinic value of the stock, you should project the Earning per share for the next 10 years and then factor in a Discount factor (as we know that money received in the future is worth less today) of 5%.

In our example, the project Earning per shre for next year is 114% x $2.21 = $2.87 and 114% x $2.87 = $3.73 for the subsequent year after next. The discount value can be extracted from Present value table. A discount rate of 5% will be us 0.95 for the first year, 0.91 for the 2nd year, 0.86 for the 3rd year etc.... Then we can caculated teh discount rate of each year by multiplying the projected EPS and Discounted factor for that year. Finally, we can add up all the discounted values for the next 10 years to give us the intrnic value. In our calculation, the intrinic value for Stock A is $35.65. Stock A share is price at $54 per share in our example, which is higher than the intrinic value in our calculation of $35.65. However, if you factor into a the good P/E ratio of 17, then even though it is trading above the intrinic value, it could still be a good buy provided the company can substain an average P/E ration of 17. P/E ratio is highly influenced by Market valuation of the stock.

In conclusion, if the company is of good economic Moat, give good ROE evey year and have sustainable competitive advantage, then if the company A stock is trading below $35.65, then it will be a very good buy indeed.

I have a spreadsheet that help me to calculate the intrinic value. The output is shown below:

An Important point to note is that in our example here, we use the Company A earning per share to calculate the intrinic value. Note that Earning per share comes from the profit and Loss section of the company financial statement. As Earning can be manufacture and it is dangerous to just accept the company earning reported as it is. To be more accurate, we should use the Operating Cash flow or Free Cash Flow to calculate the intrinic value. Why? Cash flow statement reflect how much money the company is holding, which under normal circumstance, it really reflect the true state of the company financial health.