What a share is worth
A share is worth the cash the business will make for its owners over its life. The hard part is that nobody knows that number.
A lemonade stand
A stand makes €1,000 a year, every year. Would you pay €10,000 for it? That is ten years of profit, a return of 10% a year. Pay €20,000 and the return halves to 5%. Price decides the return.
Price to earnings
The price divided by the yearly profit per share is the P/E. A P/E of 20 means paying 20 years of today’s profit. A high P/E bets that profit will grow; it is not cheap or dear on its own.
Later money is worth less
A euro in ten years is worth less than a euro today, because today’s euro could earn interest meanwhile. Valuing a company means adding up its future cash, each year counted for less the further away it is.
Margin of safety
Benjamin Graham, in The Intelligent Investor (1949), asked buyers to leave room for being wrong: pay clearly less than your estimate of value. Estimates are often wrong; the margin is what protects you.
Why many choose an index
Thousands of professionals estimate these values every day, and most of them do not beat the index after costs. Owning the whole market accepts its price instead of trying to beat it.
Key takeaways
- The price you pay sets your return.
- P/E is years of today’s profit, not a verdict.
- Leave a margin for being wrong.