A stock split is when a company decides to exchange more shares at a lower price for stockholders' existing shares. They happen from time to time, so it's important for us as investors to understand what that means.
Stock splits make stocks more accessible to individual shareholders, make selling put options cheaper, and typically tends to increase share prices in the short run. So does a stock split impact your investment if you already own the stock? It shouldn’t, because your investment should be the value of the entire business no matter how many pieces it is split into.
There's another kind of stock split which is called a reverse stock split, where you end up with less shares than you previously started with. For instance, let's say you had 100 shares and they reverse split it 10 to 1, you suddenly have 10 shares. Does it increase the value or decrease the value? Not at all.
Rule #1 investors look at the company not per share. They look at it as a whole company the way an owner does. This is why the company evaluation process is a critical step in investing—if not the most important.
The company evaluation process includes confirming that the business has a margin of safety. Margin of Safety is the discount rate you can buy a wonderful business, which is generally 50% off the Sticker Price. Because the Margin of Safety is just 50% of the Sticker Price, it allows you the ability to purchase into the business with lower risk. Setting this limitation on the price of a business before you buy it helps protect you by providing an extra 50% cushion off the value of the company. Since you must do a lot of research before buying a business, it should always be something you’re confident in purchasing. However, anything can happen in the stock market, and it makes sense to allot yourself an extra measure of protection. Buying at 50% off does just that.
Another way to evaluate a company is by evaluating the business’s moat. Moat is the durable competitive advantage that a company has that protects it from being attacked by competitors.
Moat is what makes a company predictable and allows us to put a value on the business. Charlie Munger said that “Coca-Cola is the perfect business because it has this gigantic durable competitive advantage, or moat, which gives it predictable cash flow.” This allows us to figure out what the future cash flow will be and value the company today, so we know whether we can buy it on sale or not.
Today, Phil answers fan questions regarding stock splits, company valuation, and explains why it’s important to do your research and due diligence before committing to any companies on your watchlist.
If you want to learn more about how to find excellent companies at attractive prices, download Phil’s Four Ms for Successful Investing Checklist: https://bit.ly/3jV5QAn
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