Tag: Stocks

“Time in the market beats timing the market”

Most investors believe that the best time to buy stocks is during a downturn or a ‘dip’.

But the question is – is buying the dip a good long-term investment strategy?

The truth about ‘buy the dip’

First, let’s understand what it means to ‘buy the dip’.

A dip is a decline in stock prices, across the broad market. The price drop of individual stocks and the price drop of stocks in a specific sector are also referred to using ‘dip’.

A dip can be a decline of 5% or 50%. Buying the dip means buying stocks when the dip occurs. Stock prices plummet in a dip. So retail investors looking to ‘buy the dip’ purchase those stocks, whose prices have declined.

Investors do this with the belief that the stock’s price will rise soon back to its previous highs. That means, you get the stocks for a discount, and make money as soon as the stock price returns to its previous level.

Sounds like the perfect strategy, doesn’t it?

Before you answer that let’s look at how this strategy will play out in real life.

Buying the dip

Buying the dip perfectly aligns with the ‘buy low, sell high’ outlook. That’s one reason why a lot of people choose this strategy. But what they don’t realize is that market timing is nearly impossible. So it does not matter how experienced you are, you just can’t predict the ‘lows’ and ‘highs’ in the market.

Nevertheless, let’s see how buying the dip will play out in real life.

Suppose you have decided to buy stocks when the market dips at least 20% from its highs. The plan is to wait till the market declines 20%, and then load up all the stocks you’ve been waiting to buy.

But before that, here are some questions you’ll need to ask yourself.

How long does it take for the market to go down 20%?

Once you decide you’re going to invest only when the market goes down at least 20%, you’ll need to wait for that moment. And believe me, it’s going to take a long time before you witness a dip of that magnitude.

You see, price drops aren’t that common. Since 1965, there have been only 8 drawdowns of 20% or more in the United States, once every seven years on average. That means you’ll be sitting on the sidelines with piles of cash, waiting for the market to go down, while regular investors grow their money by consistently investing in the market.

And even when the market finally goes down and you jump in and buy stocks at a 20% discount, it won’t matter. Because while you were waiting for the dip, the market went up 80%. That means, even with a 20% discount, you’re buying stocks for a 60% premium.

Even when the market rebounds and returns to its highs, you’d only have made a profit of 20%, whereas long-term investors who had been in the market all this time, managed to grow their money by 80%.

What if the market keeps going down?

This is another question you need to ask yourself; what if the market keeps on going down even after you buy the dip? What will you do then?

No, this is not an unlikely scenario. It has happened in the past, and it’s likely to happen in the future.

Because it’s impossible to predict how low the market will go. So buying at the lowest point is not exactly possible. For all you know, a small dip might be a major market crash, and it might take quite some time for the market to recover. So if your idea is to make some quick profits by buying the dip, you’re most likely to end up losing your money.

How sure are you about the market bouncing back?

The whole point of buying the dip is the belief that the stocks will bounce back, and they will go even higher.

But you’re not buying the whole market, only individual stocks. So hoping your target stocks will bounce back along with the broad market, is not a sound investment strategy. If you don’t analyze the fundamentals of each stock you might end up holding stocks that might not go up in the near future. You need to look at factors like; how the dip/crash has affected the business, how the company plans to bounce back, are there any permanent damages, and more.

Consider the case of airlines after the pandemic. Airlines were one of the many industries that were hit by the pandemic. As countries went into lockdowns, travel came to a halt. And most airline stocks tanked in March 2020.

Now, imagine your excitement seeing this dip. You see this as the perfect opportunity to pick up some good airline stocks for a discounted price. Because, why not? The stocks will be up, once the restrictions are lifted, and people start flying again.

But if you dig deep enough, you’ll find that the pandemic has changed a lot about airline industries and specifically, the part where people fly. You see, airlines made the most money from business travels, and that has been replaced by Zoom. Also, ask yourself, is this going to be the last pandemic we’re going to see in our lifetime?

The point is, blindly jumping at the opportunity to buy a stock at a discount is never a good idea. Especially if you are not sure what caused the dip in the first place.

What if you miss the best days in the market?

Another reason why waiting on the sidelines is a bad idea.

According to this data going back to 1930, Bank of America found that if an investor missed the S&P 500′s 10 best days in each decade, total returns would be just 91%, significantly below the 14,962% return for investors who held steady through the downturns.

There you have it. The final nail in the coffin.

We’ve already established that it’s impossible to time the market accurately. So the only way to make sure you don’t miss the best days in the market is to stay in the market. That means, not sitting on the sidelines, but actively investing in the market. That’s your best shot at making sure you don’t miss out on the massive gains from the 10 best days.

What if you can’t buy when the dip occurs?

Yet another aspect that investors overlook; the psychology of investing.

“Buy the dip is one of those things that works well on paper, but it doesn’t work well in real life”, says Callie Cox, senior investment strategist with Ally Invest. “It’s something that I struggle with because as an investor, I want to buy the dip, but I’m human and sometimes I don’t feel good when the market’s going down’’, said Cox.

This is the truth. It’s hard to buy more stocks when everyone is selling. Because we are humans, and we are wired to follow the crowd. The bandwagon effect explains this. It is a psychological bias that causes people to think or act a certain way if they believe that others are doing the same.

That’s the reason why most investors when they go through dips in the market, do nothing. While many would sell portions of their portfolio, only a few have the stomach to buy more shares.

What to do instead?

The wise alternative would be to stay invested in the stock market. Only then you’ll be able to fully reap the benefits of compounding. You see, if you invest $10,000 in the market earning 5% a year, in 20 years it would be worth $26,533. If you can manage to get that to 10% a year, the investment would be $67,275, in the same period.

That is the reason Albert Einstein described compounding as the ‘greatest mathematical discovery of all time’. And the more time you stay invested, the more valuable the investment will be.

Dollar-cost averaging

Dollar-cost averaging is one of the popular methods you can use to invest consistently. It is a strategy where the same amount of dollars are invested at a regular, predetermined interval. For example, $100 every month for the next 20 years.

This can help you maintain consistency in your investments and reap the benefits of long-term compounded gains. You can also dollar-cost average into index funds or exchange-traded fund (ETFs).

Bottomline

If you’re going to invest, do it consistently. Don’t wait on the sidelines waiting to buy dips. As a long-term investor, you’re likely to witness major and minor dips along the way. If you can see it as an opportunity and buy more shares of the stocks you own – good. If not, that’s okay, just make sure you don’t sell in panic.

Now, everything is obvious in hindsight. It’s easy to look back at March 2020, and regret not entering the market in March. Don’t be fooled by these thoughts.

Stay in the market. Buy stocks whenever you can, dip or no dip.

If you would like to know more strategies that can help in an adverse situation in the market, check out our guide on Bear Market Investing.

What is enterprise value (EV)?

In its simplest form, enterprise value (EV) is the theoretical takeover price of a company. Meaning, it is the company’s market value, which you need to pay for acquiring it.

A company’s enterprise value is seen as a comprehensive alternative to its market cap and is mostly used in Mergers and acquisitions, as it gives an estimate of how much the buying entity must pay to take over the company. Enterprise value is a better alternative to market cap since it considers both the debt and the cash on the company’s balance sheet.

This is is how you can calculate enterprise value –

Enterprise Value = (Market cap + debt) – cash

Market capitalization (also known as equity value) is the company’s perceived value by the stock market participants. It is calculated by multiplying the company’s stock price by the number of outstanding shares (shares that are available to the public to trade). And that is basically the total value of all the shareholder’s stakes in the company. So if you want to take over the whole company, that’s what you need to buy first.

Second, comes debt. Once you acquire the company, whatever debt the company has, is your responsibility, and would need to pay that off eventually. So that’s is added to the total cost of acquisition.

The next is cash. And that’s deducted from the total cost. Because whatever cash the company has, it’s yours once you take over the company. That cash can be used to repay some of the debt. So it makes sense to deduct it from the total amount you need to pay for the company.

Components of Enterprise value

Market capitalization

Market capitalization can be calculated by multiplying the number of outstanding shares by the share price.

For example, if a company has 50 million shares outstanding, and the share price is $100, then the market cap is $5 billion (50 million shares x $100 per share).

Preferred stock

Preferred stock is technically equity. But depending on how it is issued it can also act as debt. For example, a preferred stock that must be redeemed at a future date at a certain price is, by all definitions, debt. And in most instances, preferred stockholders are entitled to a larger fixed dividend compared to common stockholders. They also have a higher priority in asset and earnings claims.

Since the preferred stock has a larger claim on the business, the holders must be repaid in a takeover. So similar to debt, it is taken into account when calculating the enterprise value.

Debt

Acquiring a company equals, acquiring everything the company owns and owes.

This includes both long-term and short-term debt. So once you’ve taken over a company, it is your responsibility to pay it back to the creditors. Let’s say a company is worth $50 million, and the company has $10 million in debt. So even after you pay $50 million to buy the company, you still need to pay off the debt, which is an additional $10 million. So your total cost is $60 million.

This is the reason debt is added to the enterprise value of a company.

Cash

When you acquire a company, the cash is yours to use, just like the debt is yours to pay.

This includes cash in the bank and other cash equivalents, like short-term debt and marketable securities. Cash reduces the acquisition price. As cash is the most liquid asset the company owns, it is assumed that the buyer will use it immediately to pay off a portion of the debt. So cash is deducted from the enterprise value.

What is the use of Enterprise value?

Enterprise value in investing

Enterprise value is used by investors to value a company. Especially investors who follow the value investing strategy, often use enterprise value as a metric to compare companies in the same industry.

Investors also use the EV/EBITDA also known as the EV multiple, in valuing a company. EBITDA stands for earnings before interest, tax, depreciation, and amortization. EV multiple is often used as an alternative to the traditional P/E ratio.

Unlike the P/E ratio, EV/EBITDA takes into account debt and the cash the company has.

Enterprise value in Mergers and Acquisitions

Enterprise value is very useful in mergers and acquisitions. In fact, enterprise value is considered a more accurate measure of the value of a company compared to its market cap. The reason being, enterprise value takes debt into account, which must be paid by the buyer when acquiring a company.

Because two similar companies with the same market cap can have different enterprise values.

If a company has a market capitalization of $100 million and $10 million in cash and no debt, its enterprise value will be $90 million ($100 million + zero debt – $10 million cash).

Meanwhile, an identical company that has a market cap of $100 million and $20 million in debt, and $5 million in cash, will have a market cap of $115 million ($100 million + $20 million – $5 million).

In this scenario, we can see that the first company is cheaper to acquire, since it does not have any debt to pay off, and they have spare cash.

Consider the examples of Advanced Micro Devices (AMD) American Airlines (AAL). AMD has an enterprise value of $130 billion which is less than its market cap ($134 billion). Whereas in the case of AAL, the company has a market cap of $12.8 billion and an enterprise value of $43.19 billion – almost 4x its market cap!

The reason is American airlines have a lot of debt and as a result, you need to pay a lot more than its market value in order to acquire the company. AMD, however, has very little debt, and as a result, has an acquisition price (enterprise value) that is less than its market cap.

And as you can see, enterprise values can also be used to compare companies with different capital structures. Capital structure is the combination of capital that is used to fund a company. That includes shareholder equity, debt, and preferred stock. And a difference in capital structures can affect the enterprise value.

There are some downsides to using enterprise value in the valuation of a company. When using enterprise value, a company with a relatively high amount of debt might be seen as less of a prospect than a company with less debt. What many fail to realize is that their competitors also have similar levels of debt.

A better way to use enterprise value when valuing a company is to look at other companies in the same industry.

How can you use Enterprise value?

Even if you don’t want to take over a company, you can use EV multiple in valuing companies. Remember, it is a more accurate representation of what a particular company is worth. And you can use it to identify whether the company is overvalued or undervalued.

A low ratio relative to peers might indicate that the company might be undervalued, and a higher ratio means the company might be overvalued. Then again, companies in high-growth industries tend to have a higher ratio compared to companies in slow-growth industries.

Ideally, when using EV multiple, you should compare the ratio of a company with similar companies in the same industry.

Key Takeaways

• Enterprise value is the total takeover price of the company. It includes the equity and debt capital of the company.
• It is mostly used in Mergers and acquisitions as it provides an accurate cost of acquiring a company.
• Enterprise value can also be used by individual investors in comparing companies within an industry.

To learn more about valuing companies, check out our bestselling book The 8-Step Beginner’s Guide to Value Investing.