“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”  – Paul Samuelson

My Simple System for Knowing When to Buy a Stock

A reader wrote:

“I’ve read your strategy for buying income-producing real estate. You determine whether the asking price is fair or not with a simple formula: 8 times gross rent. What I want to know is if you have such a simple formula for determining the value of a particular stock, both for making the initial purchase and for reinvesting the dividends.”

Good question!

Determining a “fair” price for a dividend stock is a bit more complicated than it is when you are valuing income-producing real estate.

For one thing, businesses are more complex and dynamic than real estate properties. And the market in which rental properties exist tends to be local, which means easier to understand. Plus, rental income itself tends to be relatively stable. Rents can move up or down, but it happens gradually over a period of years, not months or even days, which can happen with stocks.

Using the 8 x GR (8 times gross rent) calculation makes it easy for me to know when not to buy. The only really bad rental property I bought in the last 15 years was the one I got talked into paying something like 15 times gross rent for.

There isn’t a calculation nearly this simple and accurate for deciding when to buy stocks. But there are ways to value stocks that are favored by people that do stock analysis for a living.

Two of the simplest are the P/E ratio and the P/R ratio. The P/E ratio compares the price of a company’s stock to that company’s profits (or earnings). The P/R ratio compares the price of a company’s stock to that of the company’s revenues.

The logic behind both is the same: If the company’s current ratio is higher than its historical average, it is deemed expensive. If it’s lower than its average, it’s deemed to be  selling at a discount.

Take Coca-Cola, for example. Its current P/E ratio is 28. This is 5 points higher than its P/E for the last 5 years (23) and 8 points higher than similar companies such as PepsiCo and Mondelez International (20).

A great time to buy Coke was (I’m not bragging) when I bought it, in 2015. Back then, it had a P/E ratio of only 20, which was, as you can see, relatively cheap.

Dan Ferris, editor of Extreme Value and a colleague of mine, did a study of Coke’s fluctuating values about a dozen years ago. I don’t remember the details, but I remember his conclusion: Even with a world-dominating brand like Coke, it does make a difference when you buy it. You should look to buy at or below its long-term value, whatever valuation method you use.

I rely primarily on the P/E ratio to value the “priciness” of a stock because of its simplicity and relative reliability. But I always ask Dominick, my broker, to take a deeper dive into evaluations when he thinks it’s merited.

Like using the GRM method for valuing rental real estate, using the P/E ratio for stocks can make it difficult or even impossible to buy more stock in good companies for years and years.

When the market is generally overpriced, P/E ratios are generally overpriced. And this is especially so when your portfolio consists of large, market dominating companies. There are times when you have to wait months or even years before the price of one of these great stocks comes into a safe buying range.

During these times, the cash portion of your stock account will get larger. You may be tempted to buy stock even if the P/E is high – especially if there are reasons to believe that the stock market or one of your stocks is going to move up.

When this happens, I sometimes ask Dominick if he can find any similarly large and dominating company that I don’t own and whose stock is NOT overvalued from a P/E perspective. If he can, we talk about whether it makes sense to expand the portfolio to include this extra stock.

There have been a few times when I’ve invested the cash in my stock account on some other type of investment – real estate, private equity, or private debt. But generally I’m comfortable sitting with cash since, because of how I diversify my portfolio, that cash is never more than 5% or 6% of my net investible wealth.

I’m not suggesting that this way of valuing stocks makes sense for everyone or even anyone reading this essay. I’m answering a good question by explaining what I do and have been doing for many years. So far, it’s been working well for me.