Imagine for a moment that you are interested in buying a small business, and you are considering two different companies. Both are really great local businesses, have solid products and a broad customer base, are debt free, and have revenues of $1 million per year. And they both have a profit margin of 15%, meaning you will get $150,000 before taxes every year just for owning the company.
All else being equal, which one should you buy? First, let’s ask what price the current owner is asking for the company.
The owner of one business is asking $3,000,000 for the company. At that price, it will take you 20 years of current revenue and profit to earn back your investment. But with projected growth, most people think this is a fair price. If the growth doesn’t pan out, the $3 million you paid could drop substantially if you try to sell the company later.
The second business owner is asking $1,500,000 for the company. At that price, you’ll earn back your entire investment in 10 years, plus benefit from projected growth. And there is always a chance that someone will come along sooner and offer you $3,000,000 for the company. If the growth doesn’t pan out, $1.5 million is still a fair price to resell the company later — something we call a “margin of safety“.
|Company One||Company Two|
|Payback Years (P/E)||20||10|
With a payback period of only 10 years, and a margin of safety built into my purchase price, I’ll take Company Two any day. So would Benjamin Graham, Warren Buffett, and a significant (but rare) group of great investors. Of course, we’re looking at far more data points when actually purchasing a company — earnings growth, dividend growth, free cash flow, price momentum, and more — P/E is not a good measure by itself, but you get the idea.
Unfortunately, many investors are chasing after Company One, hoping someone else will decide it is worth even more than $3 million after they buy it (the “greater fool theory“). In time, they’ll discover they bought a $1.5 million company for $3 million.
In the stock market, we’re not buying entire companies for millions of dollars. But rather shares, or a small percentage of an entire company. The same principles hold true regardless — buy good companies, with good financial statements, and buy them at a price that leaves room for you to profit while minimizing the chance of loss.
There are plenty of companies that meet these criteria. And if you can’t find any right now, just wait. When the last of the greater fools realizes he is last, he’ll gladly take your $1.5 million for a great company that he bought at the wrong price.