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“Buy Low and Sell High”: Why It’s Harder than It Looks

There is a little jest in the saying above.

Of course, we hope that we buy our shares at the lowest possible price, and we hope to sell it for the top dollar. But, the hope of perfectly “buying low and selling high” every time rarely materialises. Part of the reason is because it is very challenging to come up with the right value for the business behind the stock ticker.

To explain more, indulge me for a moment in a simple exercise.

 Valuing future cash flows

 The value of a business is the present value of its future cash flows.

Let’s ignore the term “present value” for a moment: In simpler words, valuing a business can be done by adding up the future amount of all the cash flow that the business makes. 

To illustrate, let’s start from a basic example. 

Imagine that I own a fictitious kopi store along the busy streets of Orchard Road. This amazing kopi store brings in cash of exactly $100,000 per year — like clockwork, I tell you! My kopi store will be closed in ten years, on the dot (whoever the owner is). 

Now, say that I want to sell the store. How much would you pay for it?

  1. $1 million
  2. $1.5 million
  3. $600,000 

Would it be $1 million? That would bring you to break-even – why bother, right? Or, would it be $1.5 million? I hope you didn’t choose this answer, because you will be losing money.

Now, if you choose $600,000, you would be sitting on a profit of $400,000 in the future.

Why?

Because at $100,000 per year, my fictitious kopi store would be making $1 million over the ten years that it is in operation. So, the goal of the investor is to pay less than what the business could possibly make in the future. 

Problems with perfect assumptions 

The kopi store example above is oversimplified, of course.

The objective for the example above was to explain the basic premise of valuing a business. In real life, though, it is much harder than that. 

The astute Foolish reader would probably already have seen several problems with the example above.

For one, the cash coming in is rarely that predictable every year. A new swanky kopi store may open next door, and challenge my profits. Or, I may use my fictitious profits to open another kopi store in Tampines to increase my cash flow. Furthermore, my fictitious kopi store empire may survive beyond the ten years assumed above, or it could even close within the next three months.

Thing is, all these changes are inherently unpredictable ahead of time. Consequently, the value of a business will change along with it.

I hope you enjoyed following the simple example above. There is more to come, so check back in the coming weeks on how valuation might help you beat the Straits Times Index (SGX: ^STI).

To learn more about valuation and to keep up to date on the latest financial and stock market news, sign up for a FREE subscription to The Motley Fool's weekly investing newsletter, Take Stock Singapore

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.