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1-Page Summary of The Little Book That Beats the Market
Chewing Gum Lesson
A sixth grader named Jason has a very effective business model. He buys several packages of chewing gum for 25 cents each, and he sells each stick of gum at school for 25 cents, making a $1 profit on each pack. With six years left before he finishes high school, Jason can expect to earn $3,000 in profits before graduation day. However, if someone wanted to invest in his company (which is actually quite small), how would you value it? It’s not as straightforward as one might think because the stock market works differently than most people think it does. One way to understand that is by thinking about the value of Jason’s gum empire—it isn’t just $1 per share like many other stocks are worth; rather there should be some sort of discount or premium depending on what investors believe they’ll get out of investing in him. What would you pay for half of Jason’s enterprise? Not $1,500 because that price would merely return your money back to you. But why would Jason accept less, since he stands to earn more than that amount from half his business ?
There’s no one answer to the question of how much Jason’s chewing gum business is worth. It depends on who you ask and what they’re looking for in a valuation. Thinking through some possibilities can help us understand the stock market better, though. When you buy a stock, you’re buying part ownership of a company. That’s why stocks are also called shares—they represent partial ownership of a company.
The reason why people buy stock is to make money. Investors hope that the value of their shares will rise over time and they can sell them for a profit later. That’s why investors usually invest in any type of security, though there are other reasons as well. People have four options with their money:
If you keep your money in cash, it won’t earn any interest. It will still be the same amount after 10 years, but its purchasing power may go down because of inflation.
Put the money in a bank that is backed by the United States government – Or buy U.S. government bonds, which are also backed by the United States government. The US government is stable and will pay its debts, so investors earn interest on their investments with no risk of default or bankruptcy. However, they do face inflation risks: if prices rise faster than expected, then that investor may lose some of his purchasing power as a result.
Buy corporate bonds or emerging market bonds. These are riskier, but they pay a higher interest rate to compensate for that additional risk.
Invest in stocks.
Investing in the Stock Market
Investors who want to earn more over time than they can expect from bonds have to invest in growth. The easiest way to do that is to buy a share of a growing business. Buying a share means you own part of the company and get some of its profits.
When you are trying to decide what a stock is worth, you must estimate the company’s future earnings. However, this isn’t the only factor to consider when pricing a stock. You can also earn interest from U.S government bonds which gives you an opportunity cost of investing in stocks that are not as profitable as they could be. If there is no way for companies to make more money than by investing in government bonds, then it doesn’t make sense for them to invest in stocks and take on risk if they don’t get paid enough for doing so.
Value versus Price
Stock market prices are very volatile, and they don’t seem to have much connection with the value of a company. For example, IBM’s stock might be worth $30 one day and then $60 later on. Why? It doesn’t mean that there has been an increase in the number of computers it sells or cars GM sells. The companies may not change at all, but their share prices can still fluctuate wildly during a period of time. Stock prices obviously depend on more than just what a company is actually worth.
