If you want to make money in stock you have to buy them when they're cheap and sell them when their expensive. It's as simple as that. There is nothing else you need to know in the world of investing. The only problem is that it can be pretty difficult to actually figure out when a stock is cheap or when it's expensive. Does the price even matter when trying to assess value?
Some investors will tell you to look at the Price Earnings ratio and if the PE is low then you would deduce that the stock is cheap because the company has high earnings relative to its price. Other investors will focus on the Return on Equity metric and tell you that the ROE needs to be over 10%. Low levels of debt and a high rate of sales are also good qualities for companies to have. The question to answer is really what should the actual price that a stock is trading at actually be?
The answer to that is that you have to figure out the intrinsic value of the stock. That is not always a straight forward thing to do, but there are discounted cash flow models that help with those calculations. The premise of a DCF model is that the intrinsic value of the stock is equal to all of the company's discounted future cash flows. There are a couple of things that go into figuring that metric out, but when you've come up with an estimated value you can then compare it to the actual stock price and make a decision on whether to proceed or not.
DCF models require that you asses the free cash flow for a company. The FCF comes from the calculation of the difference between capital expenses and total cash from operations that is derived from the statement of cash flows for the company. You can find such information on websites like Yahoo! Finance and Google finance.
The FCF growth rate is also something that needs to be taken into account for these types of models. Values between 0% and 8% are typical of companies with good track records for delivering consistent FCF. If the value is lower than 0% you should question whether you should invest in that company since you believe that the company won't do as well as in the past. If the value is higher than 10% you're probably over estimating the company's ability to increase FCF over the long term.
The discount rate is important because it allows you to factor in risk into the equation. A 9% discount rate is considered low risk for a company, and a discount rate of 15% or higher would mean that the company is a fairly risky one to invest in. The last rate to keep track of is the perpetuity growth rate which fluctuates between 2% and 3% depending on whether there is a rising or falling market.
Once you've calculated the intrinsic value you should look at the Margin of Safety to see if there is any risk to you producing incorrect results. The margin of safety represents a snapshot of how inaccurate your calculations can be before you start losing on your investment. Your margin of safety should be above 30% before you invest in any company.
To ensure that you haven't made errors in your login, you must go in a review the annual reports for the company, including 10k reports and financial statements. Doing so will enable you to validate that you have made correct assumptions in your calculations for intrinsic value.
Some investors will tell you to look at the Price Earnings ratio and if the PE is low then you would deduce that the stock is cheap because the company has high earnings relative to its price. Other investors will focus on the Return on Equity metric and tell you that the ROE needs to be over 10%. Low levels of debt and a high rate of sales are also good qualities for companies to have. The question to answer is really what should the actual price that a stock is trading at actually be?
The answer to that is that you have to figure out the intrinsic value of the stock. That is not always a straight forward thing to do, but there are discounted cash flow models that help with those calculations. The premise of a DCF model is that the intrinsic value of the stock is equal to all of the company's discounted future cash flows. There are a couple of things that go into figuring that metric out, but when you've come up with an estimated value you can then compare it to the actual stock price and make a decision on whether to proceed or not.
DCF models require that you asses the free cash flow for a company. The FCF comes from the calculation of the difference between capital expenses and total cash from operations that is derived from the statement of cash flows for the company. You can find such information on websites like Yahoo! Finance and Google finance.
The FCF growth rate is also something that needs to be taken into account for these types of models. Values between 0% and 8% are typical of companies with good track records for delivering consistent FCF. If the value is lower than 0% you should question whether you should invest in that company since you believe that the company won't do as well as in the past. If the value is higher than 10% you're probably over estimating the company's ability to increase FCF over the long term.
The discount rate is important because it allows you to factor in risk into the equation. A 9% discount rate is considered low risk for a company, and a discount rate of 15% or higher would mean that the company is a fairly risky one to invest in. The last rate to keep track of is the perpetuity growth rate which fluctuates between 2% and 3% depending on whether there is a rising or falling market.
Once you've calculated the intrinsic value you should look at the Margin of Safety to see if there is any risk to you producing incorrect results. The margin of safety represents a snapshot of how inaccurate your calculations can be before you start losing on your investment. Your margin of safety should be above 30% before you invest in any company.
To ensure that you haven't made errors in your login, you must go in a review the annual reports for the company, including 10k reports and financial statements. Doing so will enable you to validate that you have made correct assumptions in your calculations for intrinsic value.
About the Author:
Getting information on value investor tools is easy if you visit the Value Investor Headquarters website which includes tools like an intrinsic value calculator.
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