Foreword
Stocks are on sale, with almost all stocks down at least 5-8% from all time highs, with some tech stocks down as much as 80-90%. Is now a good time to buy?
As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.
If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.
Stock for sale
Let’s say you are looking at a stock to buy. A month and change ago, it was selling for $100 per share, and today, it’s selling for right around $50 a share — a 50% discount in just over a month. Would you buy it? Is it a great deal?
If the stock just gets back to where it was, you’ll double your money!
Bread for sale
Let’s say a bakery opens for business, and starts selling loaves of bread at $1.50 per loaf (1). One day, out of the blue, it starts offering to sell the exact same loaves of bread for $0.75 per loaf. Would you buy it? Is it a great deal?
Competition
Now, let’s say the first bakery returns its pricing to $1.50 per loaf. And another bakery opens offering to sell the exact same loaves of bread for $100 a loaf. It gets little business, and so decides to pull the same trick, offering the same loaves of bread for $50 a loaf. Would you buy it? Is it a great deal?
Monopoly
And finally, in our last scenario, let’s say the first bakery moves out of town, and the only bakery left is the one selling loaves of bread for $50 a loaf. Would you buy it? Is it a great deal?
Price vs Value
Price is what you pay for something. Value is what you get out of buying that something. These 2 measures are related, but separate. You can easily pay way too much (price) for way too little (value)!
So, considering our bakery scenarios –
Buying a loaf of bread at $0.75 per loaf? Yes, I believe that’s a great deal.
Buying a loaf of bread at $50 per loaf when the next door bakery is selling it for $1.50? No, that’s a terrible deal, even if it was discounted 50% from the original $100.
Finally, buying a loaf of bread at $50 when its the only bakery in town? Maybe! If there is no other food around, and I desperately need to eat, I’d certainly pay $50 (if I had it!) for a loaf of bread. But if there were other food in town, I’d probably eat something else.
In all 3 scenarios, the prices I pay for the same loaf of bread changes, but the value I get — a full tummy, remains the same. Whether the value justifies the price depends entirely on my circumstance. For example, even in the first scenario, where loaves were selling for $0.75, while I would probably buy the first and maybe second loaves of bread, I probably wouldn’t buy more than that — bread is a perishable product, and once my tummy is full, there’s not much value in more bread, to me.
Stock? For sale?
So what about the stock going for 50% less per share? Is it a great deal? Well, it depends!
If you believe in the efficient market hypothesis, then one way of thinking about it is: the stock was fairly priced at $100 a share. So, $50 a share should be a great bargain. Right?
If that’s the gist of your reasoning, then consider this — if the market was indeed efficient a month ago, what makes you think the market isn’t efficient now? Why couldn’t stocks be fairly priced at $100 a share a month ago, yet still be fairly priced at $50 a share today? Maybe something has changed to justify the stock being 50% lower!
If you don’t believe in the efficient market hypothesis, then why do you think a 50% discount, from some arbitrary value to another arbitrary value, means that stocks are a bargain now? Maybe like the $50 loaves of bread, stocks are still overpriced?
Value of a stock
There are two main ways to make a profit from stocks — investing vs speculating. When you invest, you are looking to make a return based on the productive capacity of the stock. So whether the stock is cheap or expensive depends on 3 things only:
- How much return you expect to get from the stock for each dollar invested.
- How much this return increases with time.
- How much return you would like to make, for each dollar invested.
The first is generally measured by metrics like the P/E ratio, P/S ratio, etc. The second depends on your projections and expectations for the business represented by the stock. The third, and arguably the most important, is entirely a personal preference — some people expect to earn at least 8% per annum from their investments, while others may demand as high as 20%, or higher!
For example, if you’d like to make at least a 20% annual profit per dollar invested, and you don’t expect the business to improve, then investing at any P/E more than 5 simply does not make sense.
Separately, when you are speculating, you are looking to buy an asset at a price that is lower than what you’d expect someone else is willing to pay for the same asset, perhaps at a later time. In this case, the only 2 things that matter are:
- Your projection of what that someone else would be willing to pay in the future.
- How much return you would like to make for each dollar invested from now until then.
For example, if you expect someone is willing to pay $100 a share in a month, and you’d like to make a 100% return in one month, then yes, buying at $50 today may make sense.
You can always sit on your hands
The basic fundamental truth is that it doesn’t make sense to buy any asset at a price which you do not like. If you think an asset is too richly priced, even after a 50% or even 90% drop, and you don’t feel that you can make a sufficient return to justify your time and resources, then you can simply sit on your hands and do nothing.
Of course, this assumes that you have other uses for your resources, such as other investment/speculation avenues, or perhaps you think prices will get even better in the near future.
If you have no other avenues to deploy your resources, and you do not feel that prices will get better in the near future, then perhaps your expectations for returns are simply too high.
Footnotes
- $1.50 is roughly the average cost of a loaf of bread in 2021, in the USA.
Janky Thoughts 