We all have dreams of how high our stock can go, the ceiling of the stock. Will it double or triple or will it be a ten bagger? We tie our goals to those dreams. But the art of picking stocks is not about dreaming of the upside but it is actually taking care of the downside. It’s a different game altogether. You play it not to win, but you play so you don’t lose.
I still remember a video I saw on google talks from Tom Gayner of Markel insurance. He spoke of an incident where he was on the floor of the stock exchange and a gentleman came next to him, stood in a confident manner and said that this game is all about surviving for 30 years. And it stuck him that the real winners are those who survive.
We all know of people who bet everything on a stock and when it goes down, lost all their life’s earnings and possessions. That is why Warren Buffet’s rule is to “Never lose money”. If you take care of the downside, the upside will take care of itself. An analogy could be found in the game of tennis. If you are not a professional player, then you play not to serve big aces but to just get the ball on the other side of the net and survive. You hope the other player will make mistakes, hoping his ego will get the better of him. Speaking of ego, on a side note, this is the most destructive force to one’s stock returns. Thinking one is intelligent and can ace investing is the reason for the woeful returns of investors.
How do we know what the absolute low a stock can go? There is no definite answer to this question. Sometimes, the market may get depressed about the prospects and price a stock illogically (even at bankruptcy levels). This is where you get bottom bargains. But the volatility will be high with these stocks, so if you cannot stomach the ride, stay clear.
The following are some ways of getting an estimate of the floor of the stock price:
Cash on the Balance sheet
On the balance sheet, take the Cash and short term investments value and divide by the shares outstanding. This will give the Cash per share. Now if you find a business selling for its cash, then you get all other assets including property and equipment, intellectual assets etc for free. Peter Lynch used to say that if you get a stock for its cash per share of less, then good things will happen to you. One caveat though, if you take this measure, then always look at the debt the company has. If it has a lot of leverage, then take a pass. Also if its a new company on the market (within a couple of years of its IPO), then this cash has been raised from investors and is to be deployed (or squandered).
Discounted P/E of similar companies
Look for similar companies in the market, especially those that are going through a rough patch compared to this business. Look at the P/E of what they are trading for. Now discount it a little bit further. For example, if the P/E of the competitor is 8, try to settle for 6. This way, you could get a rough number to how much this stock can fall.
Discounted value of Assets
This is kind of a back of the envelope calculation, where you take the assets of the business, discount them further (inventory, property and plant equipment, goodwill), subtract the liabilities and divide it by the shares outstanding. This will price the stock for bankruptcy.
Doomsday pricing
Look at the price of the stock during the depths of recession (2001, 2008). This gives an idea of what may happen if the next recession hits. Do not base your purchase decision on this number, but always have it in the back of mind.
Using the above methods, you could come up with a floor for the stock but be ready for surprises. There is no crystal ball that will give you this number. But, at least you have done your due diligence and come up with your hypothesis. You are no longer speculating on the stock looking at the technical charts but actually investing just as you would if you were to buy the whole company in an auction marketplace.