Value Investing Based on Fundamental Analysis
The best stock investing strategy!
The value investing strategy attempts to determine the intrinsic value of a company and is based on a fundamental analysis of the company’s performance.
The intrinsic value of a company commonly differs from the stock price.
When the stock price is less than the intrinsic value, the stock is said to be undervalued and a potential purchase.
When the stock price is greater than the intrinsic value, the stock is said to be overvalued and a potential sale.
Unlike technical analysis, commonly used by traders who use price charts to identify patterns that can suggest future activity, fundamental analysis does not take the current price of a stock into account when undertaking the analysis.
The stock price is what you pay for the company’s stock on the stock exchange, whereas the value of the company is what it is calculated to be worth.
This distinction is often lost.
Warren Buffett, the celebrated successful value investor defined the value investing approach as purchasing a stock for less than its calculated value. This comment describes in a nutshell the basics of this approach.
The difference between the value of a stock and the price at which it trades was defined by Benjamin Graham, the author of the acclaimed book The Intelligent Investor as the margin of safety - the bigger the margin the better.
How to Determine Intrinsic Value
I always try to assess the value of the company first and then decide whether it is currently available at a fair (cheap) price.
Determining the intrinsic value, or stock fair value of a company, can involve some arithmetic based on present and future forecasts of the company's performance.
It usually involves discounting forecasts of future cash-flows .
The approach I use is to look for profitable companies, that is, those with a high return on equity, and place them in a watch list until the price drops to a level below the intrinsic value of the company to provide a strong probability of achieving at least a 12 - 15% per annum internal rate of return (IRR).
That is, a return comprised of a combination of capital gain (increase in share price) and dividends (half yearly and annual payments to shareholders).
If you require a greater return than 15%, the stock price needs to drop further below the calculated intrinsic value of the stock. The calculated intrinsic value of a stock is very much related to the level of return you require on your investment.
I also look, where possible, for icing on the cake in the form of franking credits which compensate me for the fact that the company has already paid tax on its profits.
Companies that are listed as having their dividends 100% franked provide me with a tax break, as they have already paid the 30% company tax rate on the dividend.
Hence my tax bill on the dividends may be reduced, or my tax refund enhanced, depending on my current assessable income.
Franking credits are only available in countries where the government has legislated to avoid double taxation, once on the company and again on the stockholder.
Tools to Help Find Value
I use a stock screener and screen for return on equity greater than 15% in the first instance.
Return on equity is a measure of the profitability of the company. Why would I be interested in looking at companies that are not profitable!!
An example of an unique stock screener is based on the value investing theory of Joel Greenblatt's Magic Formula which screens for stocks in Europe, UK, USA and other countries - for a price.
Value investing is the approach used by Warren Buffett, the world's most successful stock investor, and many other successful stock investors.
It is based on calculating the intrinsic value of profitable companies and buying them at a price below their calculated value. This reduces the risk of stock investing as the stock is being bought at a bargain price.
A variety of methods
have been developed to measure the intrinsic value of companies. Some 'relative' methods use the stock price whereas 'absolute' methods do not.
I view relative methods as being 'quick and easy' whereas absolute measures provide a greater reliability.
Was life ever meant to be easy?
The related articles below provide more detail on related value investing topics.
Related Articles A margin of safety
- helps to minimize risk and hence preserve capital. A very important value investing concept worth understanding.
Stock fair value - or intrinsic value of a stock can be calculated in a number of ways. Check them out here.
A stock screener - enables me to find the most profitable stocks to place in a watch list. See what I screen for here.
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