Guestpost by Howie Bick
We have been talking about the stock markets on the blog and the podcast on a number of occasions. One of the most popular and accessible episodes if you want to know more is the one with my friend Sandy: The Basics of Investing in The Stock Markets with Sandy.
The simple way to get a low-risk diversified exposure to the stock markets is to invest in a low-cost index fund. If that phrase caught you off guard, let me reformulate that for you: The simple way to invest your money with limited risk of loss (but also of gain) in today’s economy is to invest a portion of your paycheck every month into a basket of companies representing a portion of the economy. This is the way I would recommend for beginners to get started, mostly to get in the habit of investing.
Now for those who want to take it further or can afford to take more risks, you can invest in individual stocks. These are in my opinion more interesting to dive into but as well more time-consuming as you will need to dive into more financial reports and business reading. I am not a financial advisor, I am just expressing my opinion based on preferences and experience, and confession: When I started investing, I did not know better so I purchased both individual shares and index funds. I made my mistakes with a limited amount but hey, that is how I roll, I like to learn by doing 😉.
Luckily I started to read more, actually look into those financial reports, study how successful investors invest and what approach they use. This is also I got to know more about the most successful one: Warren Buffett.
Warren Buffett is most known for his long-term value approach to investing. The value investing strategy consists of picking stocks with long-term growth potential that appear to be trading under their intrinsic or book value.
If that sounds exciting to you and want to get started with stock analysis, you are in good hands: Howie our guest writer for today will help us find and assess these underpriced stocks.
Analyzing an Investment from a Value Point of View
A lot of the old-time investors, who have been incredibly skilled and effective at investing, have been at it for a while. They’ve been able to truly understand the meaning behind the value and have been able to find it wherever it’s been in the market. The fundamental analysis and core concepts behind value investing have been around for a while, but few have been able to stick to its fundamentals and core beliefs.
There are a variety of questions and factors that go into the analysis of stock from a value point of view, but there are a few foundational ones that every value investor needs to be aware of.
The Fundamental Metric: The Price to Earnings Ratio
The most fundamental belief behind value investing is the price to earnings ratio. The PE ratio tells you a lot about the way the market beliefs in or views the company itself. Most times, the cool or the hot companies, have very high or inflated PE ratios that are very expensive relative to the market. Oftentimes, there’s usually a market price to earnings ratio, that’s an average of all the major companies or all the ones within one index to go off of. In recent years, tech companies have been the hot companies, with an incredibly astronomical price to earnings ratio, that is only caused as a result of the frenzy of buying from the herd mentality.
The companies and businesses behind the stock determine a large majority of the earnings potential. Depending on the business, and the stage of the business will most likely determine a lot of the current earnings or earnings potential that a company possesses. Early-stage companies, which are considered high risk, high reward, often come with little to no earnings, as they are trying to establish themselves within their industry or business field. This means they’re reinvesting the money they’ve earned, in order to gain market share, pursue new business lines, or find ways to grow their businesses in any way possible.
For value investors, this is the opposite of what they’re looking for. These companies often have very low current earnings, with very expensive prices, as the market is pricing in and projecting heavy future growth within the company, and its future. This likely means, there is a lot of investment, excitement, and momentum behind a company, and it’s pricing. Most times, value investors are looking for the companies that have been around for a little while, have strong, sustainable business models, and have a secured position within the marketplace. This way, they are able to have steady and predictable earnings, and the money invested in the company is usually pretty safe, and sustainable for the long haul.
The Company’s Business Model
Another essential element of value investing is the core underlying business model. What the company or stock does to earn its income or revenue is very important. The business behind the stock or the company will determine a lot of the company’s earnings, the way it is affected by certain market effects, or market factors, and whether it is viable for the long haul.
It’s important to try and figure out what companies will be flash in pans, or fad investing.
Value investing looks for companies that have strong, and sustainable business models. It’s important to have a constant stream of cash flows and perennial earnings. Some companies are good for a short time, or have a small opportunity to capitalize, while others are long term, viable companies for long periods of time. The longer a company produces revenue or earnings, the more the investment will be worth, meaning the more value the company unlocks, appreciating to a large value, and generating more of a return for the investor.
The Company’s Growth
Most of the time, value companies have experienced a fair share amount of their growth and are in later stages of their business cycles. This means the company has produced, has a secure position within a marketplace, and is looking for more ways to generate revenue. Companies in the early stages, or the beginning stages, often have a much higher price to earnings ratios to price in the amount of future growth or market share they’ll be able to capture in the future.
The market gets excited and ambitious behind any large company that’s been able to come on to the scene strong and make noise. People are optimistic by nature and believe companies will be able to secure more market share in the future and earn more revenue.
The management team will continue to give forecasts for the type of growth it expects to capture and provide guidance on where the company is going. The management team will play a significant role in the company, as it makes the crucial and important decisions that guide the company and its actions. They are the ones who steer the ship and guide it to where they want it to go. The senior-level executives are also important to take note of, as they are the ones who are operating the company day to day, and most likely next in line to become part of the management team.
The Marketplace Dynamic
Another important aspect to consider when evaluating or analyzing a company to purchase is to understand its position within the market and its position in the marketplace. Depending on the industry they’re in, will determine the types of competitors and the competition they’re facing. Companies that are profitable and making a lot of money will attract more competition, and heavier competition as it proves to be more and more profitable.
If the company has a superior product, and a significant first-mover advantage, it’s important to take note. The tougher it is for a company to compete and play in the arena therein, the more secure their profits are, and the more appealing the company’s long term prospects are. Value companies will often have a secure place in the market, whether that means having a best-in-class type of product, or the type of infrastructure where it makes it difficult to compete with.
Each market is different, each company is different, and each competition is different. Value investors will keep a close eye on any threats to the company’s bottom line, or the company’s future earnings.
Risk vs. Reward
The fundamental aspect of investing is the risk to reward ratio and relationship. Any investment and every investment is measured or evaluated on this type of a spectrum. The higher the risk, the higher the reward. Understanding this relationship is one of the most core or innermost beliefs of value investing. It’s important to keep in mind the types of projected returns, or the risks involved in every investment. The higher the upside, the higher the downside. It’s important to keep this idea in mind when you’re evaluating a company’s dividend ratio, future projected earnings, and future projected stock price.
The relationship between the two is at the center of everything that involves an investment. Value investing keeps this at the forefront of its mind, as it looks for companies that are considered lower risk, but also lower in reward than some of the hot market movers. The market will often dictate and determine a large portion of this risk, as a lot of it will be built into the price and seen in the price to earnings ratio. The higher the price to earnings ratio, the more risk that’s prevalent in a company.
We’d also like to mention that the P/E ratio is not the only metric that determines risk. There’s also a lot of operational and market risk as well. This means any unforeseen problems in operating the business-like tariffs, errors, or new developments that might shift the company’s ability to generate income. There’s no way to foresee all the types of risks at hand for a given company or a given investment, but there is something to be said about evaluating the potential risks that meet the eye or are able to be seen. Keeping those in mind and being cautious about the types of factors that could possibly send the company into a downward decline, is important to consider when trying to invest on a value basis.
The value point of view is one of the longest standing and more effective ways of analyzing a company. It shows you the type of deal you’re getting, the potential upsides, and teaches you about a company or a given market as well. A lot of it comes down to each individual investment and each individual market, but the principles and the foundations can be used in almost any investment or in any given market. It all comes down to how good you are at analyzing or understanding the information available to you, and the type of perspective you take whether that’s aggressive, or conservative.
A lot of what value investing comes down to is evaluating all the information at hand and trying to make sense of it. Whether that means trying to understand the price to earnings ratio, the relationship between risk and reward for an investment, the types of potential growth in the future, or even a company’s given place within a market, all of these are the types of factors that are important to keep an eye on, and to evaluate when trying to analyze something from a value point of view. A lot of what financial analysts do is to try and collect these types of data and information and make something of it. If you’ve ever wondered how to become a financial analyst, a lot of them are trying to do or to help in the process of analyzing an investment.
About the author
Howie Bick is the founder of The Analyst Handbook. The Analyst Handbook is a collection of 16 guides created to help current and aspiring Analysts advance their careers. Prior to founding The Analyst Handbook, Howie was a financial analyst.
If you are still reading that is good that means you got excited by learning more about how to analyze stocks of a company! As you can see from Howie’s article, it requires much more effort than investing “passively” in low-cost index funds, but I must say I find the studying of a company interesting as well. This is also a way to learn how companies make money and if their new products/services are profitable or not. I am for example curious if Disney will make their Disney Plus streaming service profitable.
And in case you are wondering where to look for the financial reports of a company, you can find it on the companies’ websites by looking at their investor relations section. See here for Zoom, Ferrari, or Louis Vuitton for example. And keep in mind that while we considered the Price/Earning ratios, there are more metrics to consider, like Operating Margin for instance.
I would like to thank Howie once again for helping us to get started with diving deeper into stock analysis.
If like Howie you wish to collaborate for guest posting or sponsored posts please do not hesitate to reach out by e-mail firstname.lastname@example.org and of course, for everyone, do follow us on social media as well for more great content, check our Facebook, Instagram, Twitter, and join our e-mail list. I would love to connect with you!