What if, as an investment opportunity, I offered you a stake in a beverage business that had one drink as their product and that the drink possessed a taste that everyone hated. Would you invest in that? Probably not, right? And why? Because if wouldn’t be logical.
But what if I offered you a stake in the same business, but in this instance told you the business was Red Bull? How about now? Would you invest?
As human beings we are often shackled by our belief and indeed, need for things to fit into neat, logical reasoning. We search for validation for our decisions based on mathematical models; if the spreadsheet says it will be successful, then, logically, it must be.
By contrast, some of the most innovative products ever to grace our markets were developed using everything but. Logic simply never came into it. They were the product of imagination and daring and luck, and often in fact, despite this, those truly innovative products were at first rubbish. The first cars were certainly no better than horses, and the first airplanes were nothing more than flying death traps. Would you have invested in those businesses when those products were first invented? Few would, because there was no logical argument to support doing so. Yet now, those same products are revered in our society and their markets are worth billions. If we had of applied logic to the business cases when they were first developed, those two products alone would probably still be sitting on the scrap heap, and no one would have wanted a stake. No one would buy a plane that had a high propensity for killing its passengers, and certainly no one would want a car that was slower than a horse.
Some of man’s most noble achievements have been the product of imagination, daring to dream and in some cases, pure luck. Or so says Rory Sutherland.
‘Alchemy: The dark art and curious science of creating magic in brands, business, and life.” Rory Sutherland
I stumbled across Rory Sutherland on a podcast discussing a press release about the recently refurbished London St Pancras Station, which promoted the station’s champagne bar as ‘The Longest in Europe’. Sutherland’s curiosity was piqued when this bizarre fact seemed to resonate with journalists, who all faithfully reported the news. Most people wouldn’t think twice about a statement like that, but to Rory it was pure ‘Alchemy’.
Sutherland noted ‘Generally, people don’t care all that much how long champagne bars are. No one has ever, I think, asked the question ‘I feel like going to a champagne bar – can you tell me some nearby places – ordered in declining order of length.’ But to human perception, that sentence was a burst of pure green light. Because in one sentence it conveyed that this station was not a mere utilitarian transit hub – it was a place of entertainment; a destination in its own right.” Rory sees things most people don’t. He understands the foibles of human nature on a much deeper level. Curiosity and thinking are his calling cards.
If there’s such a thing as the ‘Charlie Munger of Advertising’, Rory Sutherland’s it. Like Charlie, Rory draws on an immense catalogue of disciplines. In his recent book ‘Alchemy’, Sutherland shows us that the answers to many of our problems won’t be found in science and logic, but instead through an alchemy drawing on observation, psychology, human nature, evolution, trial and error – a process he refers to as psycho-logic.
The book contains an abundance of useful analogies and mental models. Upon completing the read, you’ll have another perspective to observe the world. Little wonder, it’s recommended reading by some of the world’s most successful investors – Rajiv Jain, James O’Shaughnessy and Clifford Sosin – to name a few.
“Looking around you is the most important skill.” Nicholas Sleep
The book’s usefulness stems from the many stories it contains about the seemingly irrationality of human behaviour, businesses and life which can be explained through psycho-logic. I’ve collected some of my favourite extracts below. While they only just scratch the surface of the book’s wisdom, hopefully they provide a glimpse into a different type of seeing and thinking.
“The models that dominate all human decision-making today are duly heavy on simplistic logic, and light on magic – a spreadsheet leaves no room for miracles.”
“The economy is not a machine – it is a highly complex system. Machines don’t allow for magic, but complex systems do.”
“Problems almost always have a plethora of seemingly irrational solutions waiting to be discovered, but that nobody is looking for them; everyone is too preoccupied with logic to look anywhere else.”
“Entrepreneurs are disproportionately valuable precisely because they are not confined to doing only those things that makes sense to a committee. Interestingly, the likes of Steve Jobs, James Dyson, Elon Musk and Peter Thiel often seem certifiably bonkers.”
“When you demand logic, you pay a hidden price: you destroy magic.”
“The human mind does not run on logic any more than a horse runs on petrol.”
“Logic is what makes a successful engineer or mathematician, but psycho-logic is what made us a successful breed of monkey, that has survived and flourished over time.”
“We have faster trains with uncomfortable seats departing from stark, modernist stations, whereas our unconscious may well prefer the opposite; slower trains with comfortable seats departing from ornate structures.”
“Think about it. There are some phrases that just wouldn’t appear in the English language:
‘I chose not to be angry.’
‘He plans to fall in love at 4.30pm tomorrow.’
‘She decided that she was no longer to feel uneasy in his presence.’
‘From that moment on, she determined no longer to be afraid of heights.’
‘He decided to like spiders and snakes.’”
“More data leads to better decisions. Except when it doesn’t.”
“The need to rely on data can also blind you to important facts that lie outside your model.”
“Strangely, as we have gained access to more information, data, processing power and better communications, we may also be losing the ability to see things in more than one way, the more data we have, the less room there is for things that can’t easily be used in computation.”
“Bad maths can lead to collective insanity, and it is far easier to be massively wrong mathematically than most people realise – a single dud data point or false assumption can lead to results that are wrong by many orders of magnitude.”
“Just a few wrong assumptions in statistics, when compounded, can lead to an intelligent man being wrong by a factor of about 100,000,000 – tarot cards are rarely this dangerous.”
“A single rogue outlier can lead to an extraordinary distortion of reality – just as when Bill Gates can walk into a football stadium and raise the average level of wealth of everyone in it by $1m.”
“We should at times be wary of paying too much attention to numerical metrics. When buying a house, numbers (such as number of rooms, floor space or journey time to work) are easy to compare, and tend to monopolise our attention. Architectural quality does not have a numerical score, and tends to sink lower in our priorities as a result, but there is no reason to assume that something is more important just because it is numerically expressible.”
“Our brains did not evolve to make perfect decisions using mathematical precision – there wasn’t much call for this kind of thing on the African savannah. Instead we have developed the ability to arrive at pretty good, non-catastrophic decisions based on limited non-numerical information, some of which may be deceptive.”
“The risk with the growing use of cheap computational power is that it encourages us to take simple, mathematically expressible part of a complicated question, solve it to a high degree of mathematical precision, and assume we have solved the whole problem.”
“We fetishise precise numerical answers because they make us look scientific – and we crave the illusion of certainty. But the real genius of humanity lies in being vaguely right – the reason that we do not follow the assumptions of economists about what is rational behaviour is not because we are stupid. It may be because part of our brain has evolved to ignore the map, or to replace the initial question with another one – not so much to find a right answer as to avoid a disastrously wrong one.”
“To use the analogy of the needle in the haystack, more data does increase the number of needles, but it also increases the volume of hay, as well as the frequency of false needles — things we will believe are significant when really they aren’t. The risk of spurious correlations, ephemeral correlations, confounding variables, or confirmation bias can lead to more dumb decisions than insightful ones, with the data giving us a confidence in these decisions that is simply not warranted.”
“In reality, all valuable information starts with very little data – the lookout on the Titanic only had one data point .. ‘Iceberg ahead,’ but they were more important than any huge survey on iceberg frequency.”
“The data might suggest people won’t pay £49 for a jar of coffee and that’s true, mostly. However people will pay 30p for a single Nespresso capsule which amounts to a similar cost – without understanding human perception it is unable to distinguish between the two. Big data makes the assumption that reality maps neatly on to behaviour but it doesn’t. Context changes everything.”
“We should also remember that all big data comes from the same place: the past. Yet a single change in the context can change human behaviour significantly. For instance, all the behavioural data in 1993 would have predicted a great future for the fax machine.”
“It is possible to construct a plausible reason for any course of action, by cherry-picking the data you choose to include in your model and ignoring inconvenient facts. The more data you have, the easier it is to find support for some spurious, self-serving narrative. The profusion of data will not settle arguments: it will make them worse.”
“Metrics, and especially averages, encourage you to focus on the middle of a market, but innovation happens at the extremes.”
“If you look at the history of inventions and discoveries, sequential deductive reasoning has contributed to relatively few of them.”
“A good guess which stands up to observation is still science. So is a lucky accident.”
“Business and politics have become far more boring and sensible than they need to be.”
“Most valuable discoveries don’t make sense at first; if they did, somebody would have discovered them already.”
“In coming up with anything genuinely new, unconscious instinct, luck and simple random experimentation play a far greater part in the problem-solving process than we ever admit.”
“We constantly rewrite the past to form a narrative which cuts out the non-critical points – and which replaces luck and random experimentation with conscious intent. In reality almost everything is more evolutionary than we care to admit.”
“It is surprisingly common for significant innovations to emerge from the removal of features rather than the addition. Google is, to put it bluntly, Yahoo without all the extraneous crap cluttering up the search page. Similarly, Twitter’s entire raison d’etre came from the limitation on the number of characters it allowed. McDonalds deleted 99% of items from traditional American diner repertoire; Starbucks placed little emphasis on food for the first decade of its existence.”
“In the early stages of any significant innovation, there may be an awkward stage where the new product is no better that what it is seeking to replace. For instance, early cars were in most respects worse than horses. Early aircraft were insanely dangerous. Early washing machines were unreliable. The appeal of these products was based on their status as much as their utility.”
“To solve logic-proof problems requires intelligent, logical people to admit the possibility they might be wrong about something, but these people’s minds are often most resistant to change – perhaps because their status is deeply entwined with their capacity for reason.. Highly educated people don’t merely use logic; it is part of their identity. When I told one economist that you can often increase the sales of a product by increasing its price, the reaction was one not of curiosity, but of anger.”
“It is perfectly possible to be both rational and wrong. Logical ideas often fail because logic demands universally applicable laws but humans, unlike atoms, are not consistent enough in their behaviour for such laws to hold very broadly.”
“Imagine you are a company whose product is not selling well. Which of the following proposals would be easier to make in a board meeting called to resolve the problem? a) ‘We should reduce the price’ or b) ‘We should feature more ducks in our advertising.’ The first of course – and yet the second could, in fact, be much more profitable.”
“The fatal issue is that logic always get you to exactly the same place as your competitors. Our mantra is, ‘Test counterintuitive things, because no-one else ever does.’”
“Stubborn problems are probably stubborn, because they are logic proof.”
“All progress involves guesswork, but it helps to start with a wide range of guesses.”
“If a problem is solved using a discipline other than that practised by those who believe themselves the rightful guardians of the solution, you’ll face an uphill struggle no matter how much evidence you can amass… Surgeons felt challenged by keyhole surgery and other less invasive procedures that can be carried out with the support of radiographers, because they used skills different from those that they had spent a lifetime perfecting.”
“Human behaviour is an enigma. Learn to crack the code.”
“Real life is not a conventional science – the tools which work so well when designing a Boeing 787, say, will not work so well when designing a customer experience or a tax programme. People are not nearly as pliable or predictable as carbon fibre or metal alloys, and we should not pretend that they are.”
“Hillary thinks like an economist, while Donald is a game theorist, and is able to achieve with one tweet what would take Clinton four years of congressional infighting. That’s alchemy; you may hate it, but it works.”
“The single worst thing that can happen in a criminal investigation is for everyone involved to become fixated on the same theory, because one false assumption shared by everyone can undermine the entire investigation. There’s a name for this – it’s called ‘privileging the hypothesis.’
“If science did not allow for such lucky accidents, its record would be much poorer – imagine if we forbade the use of penicillin, because its discovery was not predicted in advance. Yet policy and business decisions are overwhelmingly based on a ‘reason first, discovery later’ methodology, which seems wasteful in the extreme. Evolution, too, is a haphazard process that discovers what can survive in the world where some things are predictable but others aren’t. It works because each gene reaps the rewards and costs from its lucky or unlucky mistakes, but it doesn’t give a damn about reasons.”
“Conventional logic is a straightforward mental process that is equally available to all and will therefore get you to the same place as everyone else.”
“The models of human behaviour devised and promoted by economists and other conventionally rational people are wholly inadequate at predicting human behaviour.”
“Notice that ordinary people are never allowed to pronounce on complex problems. When do you ever hear an immigration officer interviewed about immigration, or a street cop interviewed about crime? These people patently know far more about these issues than economists or sociologists, and yet we instead seek wisdom from people with models and theories rather than actual experience.”
“If this book provides you with nothing else, I hope it gives you permission to suggest slightly silly things from time to time. To fail a little more often. To think unlike an economist.”
“The 2008 financial crisis arose after people placed unquestioning faith in mathematically neat models of an artificially simple reality.”
“In any complex system, an overemphasis on the importance of some metrics will lead to weaknesses developing in other over-looked ones. It’s surely better to find satisfactory solutions for a realistic world, than perfect solutions for an unrealistic one.”
“After all, no big business idea makes sense at first. I mean, just imagine proposing the following ideas to a group of skeptical investors .. ‘What people want is a really cool vacuum cleaner’ (Dyson), ‘And best of all the drink has a taste which consumers say they hate.’ (Red Bull), ‘.. and just watch as perfectly sane people pay $5 for a drink they can make at home for a few pence’ (Starbucks).”
“The evolutionary psychologist Robert Kurzban, explains that we do not have full access to the reasons behind our decision-making because, in evolutionary terms, we are better off not knowing, we have evolved to deceive ourselves, in order that we are better at deceiving others.”
“If you want to change people’s behaviour, listening to their rational explanations for their behaviour may be misleading, because it isn’t the real why.”
“We consciously believe our actions are guided by reason, but this does not mean that they are – it may simply be evolutionary advantageous for us to believe this.”
“One astonishing possible explanation for the function of reason only emerged about ten years ago: the argumentative hypothesis suggests reason arose in the human brain not to inform our actions and beliefs, but to explain them and defend them to others. In other words, it was an adaption necessitated by our being a highly social species. We may use reason to detect lying in others, to resolve disputes, to attempt to influence other people or to explain our actions in retrospect, but it seems not to play the decisive role in individual decision-making. In this model, reason is not as Descartes thought, the brain’s science and research and development function – it is the brains legal and PR department.”
“The fact that we can deploy reason to explain our actions post-hoc does not mean that it was reason that decided on that action in the first place, or indeed that the use of reason can help obtain it.”
“Just as we infer a great deal about an air carrier from their on-board catering, while neglecting to care about the $150m aircraft or make of the engines, we are just as likely to be unhappy with a hospital because the reception area is neglected, the magazines are out of date and the nurse didn’t spare us much time. The truth is that ancillary details have a far greater effect on our emotional response, and hence our behaviour, than measured outcomes.”
“For a business to be truly customer-focused it needs to ignore what people say. Instead it needs to concentrate of what people feel.”
Short Term Optimisation
“A company pursuing only profit but not considering the impact of its profit seeking upon customer satisfaction, trust or long-term resilience, could do very well in the short term, but its long term future may be perilous. There is a parallel in the behaviour of bees, which do not make the most of the system they have evolved to collect nectar and pollen. Although they have an efficient way of communicating about the direction of reliable food sources, the waggle dance, a significant proportion of the hive seems to ignore it altogether and journeys off at random. In the short term, the hive would be better off all bees slavishly followed the waggle dance, and for a time this random behaviour baffled scientists, who wondered why 20 million years of bee evolution had not enforced a greater level of behavioural compliance. However, what they discovered was fascinating: without these rogue bees, the hive would get stuck in what complexity theorists call ‘a local maximum’; they would be so efficient at collecting food from known sources that, once these existing sources of food dried up, they wouldn’t know where to go next and the hive would starve to death. So the rogues bees are, in a sense, the hive’s research and development function, and their efficiency pays off handsomely when they discover a fresh source of food. It is precisely because they do not concentrate exclusively on short-term efficiency that bees have survived so many million years. If you optimise something in one direction, you may be creating a weakness somewhere else.”
“The reason we do not ask basic questions is because, once our brain provides a logical answer, we stop looking for better ones: with a little alchemy, better answers can be found.”
“To reach intelligent answers, you often need to ask really dumb questions.”
“Perhaps advertising agencies are largely valuable simply because they create a culture in which it is acceptable to ask daft questions and make foolish suggestions.”
How You Ask Questions
“One of the great contributions to the profit of high-end restaurants is the fact that bottled water comes in two types, enabling a waiter to ask ‘still or sparkling?’, making it rather difficult to say ‘just tap.’”
“An inability to change perspective is equivalent to a loss of intelligence.”
Efficiency Doesn’t Always Pay
“I rang a company’s call centre the other day, and the experience was exemplary: helpful, knowledgeable and charming. The firm was a client of ours, so I asked them what they did to make their telephone operators so good. The response was unexpected: ‘to be perfectly honest, we probably overpay them.’.. The staff weren’t regarded as a ‘cost’ – they were a significant reason for the company’s success. However, modern capitalism dictates that it will only be a matter of time before some beady-eyed consultants pitch up at a board meeting with a PowerPoint presentation entitled ‘Rightsizing Customer Service Costs Through Offshoring and Resource Management.’ or something similar. Soon nobody will phone to place orders because they won’t be able to understand a word they are saying, but that won’t matter when the company presents its quarterly earnings to analysts and one chart contains the bullet point: ‘Labour cost reduction through call centre relocation/downsizing.”
“Today the principal activity of any publicly held company is rarely the creation of products to satisfy a market need. Management attention is instead largely directed towards the invention of plausible sounding efficiency narratives to satisfy financial analysts, many of whom know nothing about the businesses they claim to analyse, beyond what they can read on a spreadsheet.”
“In psychology, one plus one can equal three.”
“We don’t value things we value their meaning. What they bare is determined by the laws of physics, but what they mean is determined by the laws of psychology. Companies which look for opportunities to make magic, like Apple or Disney, routinely feature in lists of the most valuable and profitable brands in the world; you might think economists would have notice this by now.”
“Nearly all really successful businesses, as much as they pretend to be popular for rational reasons, owe most of their success to have stumbled on a psychological magic trick, sometimes unwittingly. Google, Dyson, Uber, Red Bull, Diet Coke, McDonalds, Just Eat, Apple, Starbucks and Amazon have all deliberately or accidentally happened on a form of mental alchemy.”
“According to research from the University of Illinois, descriptive menu labels raised sales by 27% in restaurants, compared to food items without descriptors.”
“So much for economic orthodoxy – in fact, it is not uncommon for premium priced products to have a high market share, as any of those financial analysts might have realised had they reached into their pockets to find an I-phone or the key to an Audi.”
“If there is a mystery at the heart of this book, it is why psychology has been so peculiarly uninfluential in business and in policy making when, whether done well or badly, it makes a spectacular difference.”
“If a customer has a problem and a brand resolves it in a satisfactory manner, the customer becomes a more loyal customer than if the fault had not occurred in the first place.”
“Much of the paraphernalia and practice of the military – flags, drums, uniforms, square-bashing, regalia, mascots and so forth – might be effectively bravery placebos, environmental cues designed to foster bravery and solidarity.”
“People want cheap, abundant and nice tasting drinks, surely? And yet the success of Red Bull proves they don’t.”
“I have never seen evidence that academic success accurately predicts workplace success.”
“It is now common practice in British firms to interview people with an upper second-class degree or above, a criterion that is applied with no evidence but simply because it is logical.”
“An unconventional rule for spotting talent that nobody else uses may be far better than a ‘better’ rule which is in common use, because it will allow you to find talent that is undervalued by everyone else.”
“As I always advise young people, ‘Find one or two things your boss is rubbish at and be quite good at them.’ Complementary talent is far more valuable than conformist talent.”
Every investor needs an edge and seeing things that others don’t can be one of those. Building a latticework of mental models provides more tools. As Charlie Munger warns, ‘to a man with a hammer, everything looks like a nail.’ One of my favourite mental models is Sutherland’s observation about the bees and the waggle dance. There’s a real analogy here for investors. If you keep doing the same things, buying the same types of investments, you might risk missing the changing world. In our portfolio we’ve started to experiment with very small positions in businesses we’d likely have overlooked a few years ago. We make an effort to read and listen to investors in adjacent disciplines like venture capital and private equity. We keep pushing into broader intellectual fields to identify lessons and mental models we can incorporate in our own investing. And we listen to investors we disagree with who test our long held assumptions about how we define successful investing. We’re hoping, like the bees and the waggle dance, it will help us survive and flourish over the long term.
‘Alchemy’ by Rory Sutherland. 2019
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Read more awesome articles like this one on VintageValueInvesting.com!
Read more great articles at Vintage Value Investing.
Title: Learning from Rory Sutherland
Sourced From: www.vintagevalueinvesting.com/learning-from-rory-sutherland/?utm_source=rss&utm_medium=rss&utm_campaign=learning-from-rory-sutherland
Published Date: Thu, 23 Jul 2020 06:39:25 +0000
Did you miss our previous article…
Are These Marijuana Stocks Built For Long Or Short Term Success?
Would You Invest In These Marijuana Stocks In 2021?
For the last several month’s investors have found a renewed interest in marijuana stocks. From mid-2020 to currently in 2021 cannabis stocks have been on the move. Many pot stocks from various niches have been rising in the market. Some marijuana stocks have not only reported record earnings but some have seen back-to-back all-time highs. With the amount of money being invested with the hopes of federal cannabis reform, people are trying to jump on board before the boat leaves the dock.
The cannabis sector as a whole has been on fire. Many companies in the cannabis industry have been preparing for what’s next to come. Meaning most cannabis companies are making operational adjustments to be able to adapt to the future of the cannabis industry. For example, 2 big-time cannabis companies both teamed up to make the biggest cannabis company on earth. Tilray Inc. and Aphria Inc. joined forces which have helped both companies market performance to a degree.
As well other companies have taken notice and may follow the same path. A lot is changing for the cannabis industry between legislation, more states going legal, and new regulations. All these variables play a factor in how this sentiment impacts the market. With more positive sentiment taking hold of the market is reflects in how well some marijuana stocks trade.
So far in 2021 cannabis stocks are moving up and seeing overall bigger gains. For this reason, many new and seasoned investors are looking to get involved and make some money. The cannabis industry is one of the fastest-growing markets in the world that is continuously expanding. The 2 cannabis stocks below are examples of when the sector is trending it resonates well with how marijuana stocks can or will trade.
Pot Stock Watch List This Month
Green Lane Holdigns Inc.
Green Lane Holdigns Inc. has been of the many marijuana stocks trying to climb higher in a volatile market. Back in 202 GNLN stock saw its price fluctuate quite often. This price fluctuation allowed for good entry points before GNLN stock had a spike in trading. Like many marijuana stocks, 2021 gave the cannabis market a nice push to start the new year. With Green Lane 2021 was no different.
In the first 2 weeks of the new year, GNLN stock shot up 25 percent in trading as it was starting to dip from this point. Even though Green Lane closed out the first month of the new year with a drop from previous highs in January the following month was a different story. Currently GNLN stock in February has been able to recover from January’s dip.
The company has been able to even reach higher highs than last month. Within the first trading week of February, GNLN stock saw gains of 27 percent. This was a much-needed momentum booster to help the company recover from its trading at the close of January. So far for in February GNLN stock has had a nice upward push in the market showing over 60 percent gains in trading. This current momentum has signaled to investors that Green Lane may be a marijuana stock to watch in 2021.
- 3 Top Marijuana Stocks To Watch This Year
- Will Cannabis Stocks See A Rise In Trading With Chuck Schumer Push For Federal Cannabis Legislation?
Liberty Health Sciences Inc.
Liberty Health Sciences Inc. has been an interesting cannabis stock to watch. Like many other cannabis businesses, it’s going to take more than a pandemic to stop the company from expanding. Back in January, the company announced that it will be opening a new location adding to its current portfolio of dispensaries. The Company plans to open two more dispensaries by the end of February 2021 with much more in the works.
Although in 2020 LHSIF stock traded mostly sideways with subtle spikes in trading the new year has provided a strong push in trading. Starting from December 21st LHSIF stock started to bounce and began to climb in the market. From the 21st to the 31st of December LHSIF stock shot up 90 percent. For those who held their position until this point, they made a healthy return on their investment. Pushing into the new year the company was able to sustain its market momentum and keep pushing up in the market.
In the first 14 days of trading of the new year LHSIF stock has a 13 percent increase in trading. The remainder of January’s trading resulted in a small dip. Yet overall gains for the first month of 2021 for LHSIF stock was an increase of 8 percent. This was a subtle push that helped the company sustain its current market position. Now that we have entered February LHSIF has continued to trade up in the market. Currently for the month of February LHSIF stock is up over 25 percent. If the company can continue this momentum it would intrigue more people to keep an eye on this marijuana stock.
By: Daniel Chase
Title: Are These Marijuana Stocks Built For Long Or Short Term Success?
Sourced From: marijuanastocks.com/are-these-marijuana-stocks-built-for-long-or-short-term-success/
Published Date: Thu, 11 Feb 2021 13:30:07 +0000
Did you miss our previous article…
Price to Earnings Ratio Defined (P/E Ratio Formula)
Trying your hand at the stock market? Chances are, you’ve come across the term “P/E ratio”. If you’re like many who are new to the stock market, you’ve looked at this phrase and asked yourself, “What in the world is that?”
P/E ratio, otherwise known as the price-to-earnings ratio, is a formula that investors use to determine the value of a company’s share. It is one of the most common formulas used to determine the value of a stock. The formula compares the price of a company’s share to the earnings per share (EPS) of the company in order to determine how much an investor is paying for $1 of the company’s earnings. Let’s take a deeper dive into the P/E formula. Use the links below to jump ahead to a section of your choosing.
P/E Formula and Calculation
First thing’s first: let’s learn the price to earnings ratio formula and how to calculate it. The price-to-earnings ratio formula is as follows: the price of a single share of a company’s stock (What is a stock?), divided by the company’s earnings per share (EPS). The ratio of these two variables will tell you exactly how much an investor is spending for a single dollar of the company’s earnings.
Finding the cost of a company’s stock is extremely simple. In order to find the price of a single share of a company’s stock, all you need to do is enter the company’s stock ticker symbol (the series of characters that represents that company on the stock market) into a finance website, such as investor.gov. You’ll quickly find the current cost for a single share of that company’s stock. Google also keeps an up-to-date Market Summary for the prior day’s stock market, so a quick Google search will often bring exactly the answer you’re looking for.
Determining a company’s earnings per share (EPS) can be a bit trickier. Earnings per share are broken down into 2 categories: trailing earnings and forward earnings. Trailing earnings, often shortened to TTM, are the company’s core earnings over the trailing, or prior, 12 months. This number is the profit that the company has generated over the past 12 months of business. Remember that we’re talking about the net income of a business, rather than the gross income (Need a refresher? Learn more about gross income vs net income.). P/E ratios calculated with trailing earnings are known as the trailing P/E (P/E TTM). Forward earnings, on the other hand, are the predicted earnings that the company will generate over the next 12 months. P/E ratios calculated using forward earnings are known as the forward P/E. Both types of earnings are divided by the total number of public shares on the market in order to generate their EPS. More on this later.
Let’s try out an example. Say you’re looking to determine the trailing P/E of a fictional company AlphaBet Corporation, known on the stock market as ABC. Their share price is currently at $50 per share. Their trailing earnings per share is $5. Divide the $50 per share by the $5 EPS, and you’re left with a P/E of 10. This means that investors are paying $10 for every $1 in earnings per share.
Understanding P/E Ratio
So, ABC has a P/E of 10. What does that mean for you?
In the most general sense, the lower a P/E ratio, the less an investor is paying for each dollar of a company’s earnings per share. A higher P/E ratio means that an investor is paying more per EPS. But, unfortunately, determining which stock to buy isn’t as simple as “look for the lowest P/E ratio”.
It is imperative to remember that everything on the stock market is relative. “Good” and “bad” numbers are different for each and every industry. An electronics company and an automotive company are functioning in two vastly different landscapes. Therefore, in order to determine what is a good price to earnings ratio, you’ll need to understand the landscape of P/E ratios in the industry. Look at similar companies’ P/E ratios to better understand the relative value of your company’s P/E ratio. If ABC’s price-to-earnings ratio seems extremely high as compared to other companies in the industry, it may be an overvalued stock. On the other hand, if it seems extremely low as compared to other companies in the industry, it may be a very valuable stock.
Let’s try another example. We’ve already determined that ABC’s price is $50 per share, earnings are $5 per share, and P/E is 10. A competitor, DOG, also has stock for $50 per share. Their earnings, on the other hand, are $2 per share, making their PE 25 (50/2=25). An investor would pay $10 for every $1 of ABC’s earnings per share, but they’d have to pay $25 for every $1 of DOG’s earnings per share. With a better understanding of the landscape, we can see how ABC sits relative to its competitors.
A company’s price to earnings ratio may also be looked at relative to itself. Remember those two types of earnings we reviewed earlier? We can compare a company’s trailing P/E to their forward P/E to better understand the value of a stock. A company with a high trailing P/E ratio may have been rather unprofitable the prior 12 months because theywere preparing to ramp up business substantially, and took on a number of upfront costs. They may be expecting a boom of profits over the forward 12 months, leaving them with a substantially lower forward P/E. By reviewing these numbers in comparison to each other, we may see an opportunity for a long-term investment.
Limitations of the P/E Ratio
While the price to earnings ratio is certainly one of the most widely used calculations among stock market investors and analysts, it’s not a cut and dry way to determine a good or bad stock. It gives investors a good understanding of the value of stock in a particular moment, but it certainly has its short-comings.
Just as the stock market is relative, it’s also in a constant state of fluctuation. It is re-evaluated and recalculated constantly. Why does this matter when it comes to the price to earnings ratio? Well, just look at the variables we use to determine the P/E ratio.
First, we have the “price” of the price-to-earnings ratio: the cost of a single share of a company’s stock. Stock prices fluctuate every single day based on supply, demand, current events, and more. Typically, the cost of a company’s stock will be reported as the cost that it was when the stock market closed the prior day. Each time a company’s stock price changes, their P/E ratio will change. Certain companies may tend to have a greater fundamental volatility than others, leaving their stock price changing substantially each and every day. Even those with low fundamental volatility experience routine fluctuation.
Next, we have the “earnings” in the price-to-earnings ratio. Both trailing and forward P/E ratios have their limitations. Trailing P/E can feel like the more reliable of the two numbers because it’s based on facts. We take their actual earnings over the prior 12 months into account. But, in many situations, a company’s prior 12 months may have little to do with their next 12 months. As mentioned earlier, a company may have spent heavy the prior 12 months in preparation to ramp up the next 12 months. The trailing P/E won’t show us any of that. The forward P/E, on the other hand, is based on predictions. And predictions are quite educated guesses, but at the end of the day predictions are still guesses. A company may fall short of their predicted earnings or blow completely past them.
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The post Price to Earnings Ratio Defined (P/E Ratio Formula) appeared first on MintLife Blog.
Title: Price to Earnings Ratio Defined (P/E Ratio Formula)
Sourced From: mint.intuit.com/blog/investing/price-earnings-ratio/
Published Date: Tue, 25 Aug 2020 19:37:02 +0000
Did you miss our previous article…
Will Marijuana Banking Be Apart Of Federal Cannabis Reform?
The Cannabis Industry VS Financial Institutions
As marijuana stocks and the cannabis industry as a whole awaits federal cannabis reform the sector keeps trending. Now if the U.S. can federally decriminalize cannabis some analysts feel it may cause some cannabis stocks to rally. As well as many new doors will that can open. For one many new markets will look to join the U.S. cannabis industry. Furthermore, with federal cannabis reform, it could be the start of initiating a banking system for the industry.
Currently due to cannabis still being federally illegal banks can not take money from a cannabis-related business. From the time states started going legal, it has been an issue that has yet to be resolved. The cannabis industry is one of the fastest-growing industries in the world, especially in the United States. Politicians have been working to pass various pieces of cannabis legislation.
The one bill that would be beneficial to the industry is known as the SAFE Banking Act. This bill would allow banks to accept money from cannabis-related businesses. On March 7, 2019, the bill was introduced to the U.S. House of Representatives by Ed Perlmutter and was introduced to the Judiciary and Financial Services Committees. Back in 2019, the Financial Services Committee voted 45 to 15 to advance the bill to the full House.
The SAFE Banking Act provisions were included in the HEROES Act COVID-19 relief bill passed in the U.S. House in May 2020. They were again included in a bill approved by the house 214–207 in October. A push to include the SAFE Banking Act provisions in the end-of-year COVID-19 stimulus failed, though hope remained it could pass in 2021 if reintroduced.
How Will The Cannabis Industry Work With Banks
When it comes to any business you can think having startup capital is important. Now not every person with money is willing to invest in a new venture which makes finding that more of a task. Especially with cannabis-related business and right now banks are no help. For a business to acquire a line of credit or some type of lending your business must be able to have some type of financial record.
This usually tells banks and lenders how good you are at paying things back and how reliable you are to do so. The bigger obstacle for cannabis businesses is how do you show you are trustworthy with no credit history. Once again this due to financial institutions not working with cannabis businesses. Let’s look at a few steps to help jump over some red tape.
First, you should start a new business that is a separate company from your personal credit. This will help when it comes time to do your taxes. The second step to take is you need to register for your EIN number. Next thing to do is open a new bank account and make sure you can show that you have continuous income which shows financial stability. Again with banks not accepting cannabis money the last step may be next to impossible to do.
- Are You Up To Date On The Cannabis Industry In 2021?
- Are These The Best Marijuana Stocks To Buy For Long Term Cannabis Investments?
Will Cannabis Banking Actually Happen?
The way financial institutions offer other industries various banking options is not the same for the cannabis industry. Although there is some grey area with cannabis and banks yet most banks won’t offer services for how high risk the industry is. This leaves many cannabis businesses left out from what other traditional retail businesses would have. Look past the risk banks also look at taking cannabis money as to much work. This would result in following regulations and keeping data on all money. This process has been established by the Bank Secrecy Act of 1970. Also, working with the large amounts of cash cannabis businesses generate may affect how a bank can operate.
With this roadblock between banks and cannabis money, it shuns cannabis businesses from establishing a form of credit. This issue alone is why the industry operates only in cash with very few places to keep it. Also, this issue can do much harm to future relationships with other companies and businesses. If a cannabis business can not establish a credit history no lender or bank can help. That’s why it’s important to have an industry as big as cannabis have some form of credit being reported to credit companies. This will tell other lenders and banks that a particular business is profitable enough to pay back any loans.
What Will The Future Of Cannabis Banking Become
It’s wild to think that an industry that is generating a high volume of cash is being blocked from showing the reliability needed to secure lending. Some feel if the cannabis business can earn the trust of financial institutions by being transparent with its earnings. This may be a step to banks feeling more comfortable with working with a cash-intensive business. Hopefully, with federal cannabis reform, it will help push cannabis banking in the direction needed to help out the industry.
By: J. Phillip
Title: Will Marijuana Banking Be Apart Of Federal Cannabis Reform?
Sourced From: marijuanastocks.com/will-marijuana-banking-be-apart-of-federal-cannabis-reform/
Published Date: Tue, 09 Feb 2021 18:34:56 +0000
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