As a follow-up on my last post which you can read here, I wanted to discuss the important difference between a company and a stock when investing. The old adage of “invest in what you know and buy” is very general and only goes so far. I would also say that it’s not nearly as useful as it was a few decades ago.
You partner with a company but the vehicle you use to do so is its stock. What I mean is that evaluating the underlying company is step #1 (you wouldn’t want to partner with a bad business) and then evaluating certain attributes of the stock is step #2. Both are very important, necessary, and must be done in that order.
Step #1: Evaluating the underlying company
When looking at LinkedIn and Twitter, I would consider both very good companies with a great product. Both are leaders in their space and I, along with millions of other people, use both sites almost daily. Unlike Facebook, if used properly, both sites actually help people increase their level of productivity. There are many other things I look at when researching a company but for the sake of simplicity in this post we’ll say they’re good companies. Step #1: check.
Step #2: Evaluating the stock as a vehicle for an investment in the company
Every public company has a certain number of shares authorized to be sold and a number that is outstanding (already issued by the company). If you take the number of shares outstanding and multiply it by the price of the stock, you get the value of the company’s equity. For example, if a company has 10 million shares of stock outstanding and the stock is priced at $10/share, the company has a market capitalization (value of equity) of $100 million (10 million x $10 = $100 million).
If I bought 1,000 shares (a $10,000 investment), I would own 0.01% of the company. (1,000 of the 10 million). That means I have 0.01% of voting rights and I am entitled to 0.01% of profits, theoretically.
Now, if a company is issuing new shares every year to its employees and executives at a rate that is increasing the number of shares outstanding by 5%, they are diluting my ownership of the company by roughly 5% per year. After one year, I would now only own approximately 0.0095% of the company. So the company has to grow at a rate of at least 5% per year in order to keep my share of earnings constant. This is what I meant when I said it’s like you’re swimming upstream every year.
Twitter – Shares Outstanding up 5.5% YoY
It’s important to note that every company grants stock to executives and may offer stock purchase plans to employees, but it all comes down to how much they’re diluting the share count each year. This is where many tech companies like LinkedIn and Twitter fail when it comes to Step #2. They grant an egregious amount of stock to the point that I cannot even consider them a realistic, prudent investment. Their stocks are simply trading vehicles for short-term swing traders. What I like to see is the exact opposite. I want to partner with great companies that are shrinking the outstanding share count each year through buybacks because that increases my equity ownership. It doesn’t have to be a lot; a simple 2% or less will do. This creates a compounding effect on top of the company’s underlying growth. If earnings grow by 8% year-over-year but they also reduce the share count by 2%, the earnings per share I’m entitled to will grow by a little over 10%. Reducing the share count, when done the right way via free cash flow, is like swimming downstream – far easier to do!
Hopefully you can see that evaluating stocks as an investment is much more than just looking at the underlying company and being blinded by Wall Street’s favorite metric of top line growth. As an outside investor, studying things like compensation packages and the company’s capital allocation policies will help to add a lot of clarity between stocks that languish despite the appearance that the company is growing and stocks that generate strong returns over time.
Thanks for following!
-Nick