Education: The Top 3 Rules to Uncovering ValueSeptember 4, 2018
Like most investors, one of your top goals has been to enjoy financial freedom at whatever age you choose. So it stands to reason that your money should ideally generate above-market returns with below market risk.
That’s Rule No. 1. Make your money work for you at all times.
With fundamental analysis, we’re trying to identify key pieces of information that will help tell us if a company is overvalued, or undervalued with good chances for upside.
Those six include:
- Competitive advantage
- Earnings growth
- Sales revenue growth
- Market share
- Product pipeline
- Quality of the company’s management
With this analysis, the goal is to buy companies at a deep discount to their intrinsic value. Billionaire Warren Buffett subscribes to fundamental analysis, for example. And, as we all know, he’s swimming in money because of it.
Using fundamental arguments, Buffett bought more than billion dollars worth of Coke (KO) in 1988. Buffett saw consistent performance and good long-term prospects based on the nuts and bolts of Coke. He also saw bargain in the stock price after years of disaster. The stock, said Buffett, wasn’t reflective of the growth set to occur in the company’s international business. So he bought in 1988, and watched his $1 billion investment in Coke explode to $12 billion by the close of 1999.
Warren Buffett does it by keeping it simple. He wants to know:
- Has the company’s performance been consistently good?
- Does the company carry too much debt compared to its peers?
- Are profit margins high compared to its peers?Are they increasing?
- Is the company cheap on a valuation level?
That brings us to Rule No. 2 – Ignoring the “Noise.”
All too often, we’re told to ignore 52-week lows because stocks hitting new lows tend to continue making new low, for example. But that’s not always the case. In fact, many stocks hitting 52-week lows are there undeservingly. It’s your job to find out which ones hold the most value and the most “bang for your buck.”
To do so, you must begin to understand the underlying nuts and bolts of the stock.
- Where does it sit fundamentally?
- Is the stock overvalued/undervalued based on its price to earning ratio?
- Is it trading at or below future growth, per its price to earnings growth ratio (PEG)?
- Is the company making a profit?
- How does the stock trade in comparison to overall sales?
- Where does the company stand with regards to competition?
- When it comes to this analysis, it’s all about earnings. How much is the company making now? How much could it make in the future? Some of the key building blocks to understanding how to value a stock can be found with price to earnings (PE), price to sales (PS), price to book (PB), return on equity (ROE) and price to earnings growth (PEG) are some of the key ones to understand.
Earnings are the bottom line. Earnings give an indication of future potential. Without earnings, a stock is on life support. This is the lifeblood of any company success. Our goal is to jump into the fast-moving roller coaster car when it’s at the bottom of a dip in the track when its fundamental strengths are being ignored.
Rule No. 3 – Only buy Financially Sound Stocks
The last thing any of us can afford to do is sink money into a stock that’s not fundamentally sound, or lacks economic moat, as Warren Buffett frequently speaks of.
To find those very stocks, we developed our own screen. To meet our criteria:
- A history of being up and staying up substantially over the last 3-5 years.
- Positive book value
- Little or no debt, plus the ability to service any debt that exists without issuing more stock and diluting shares.
- Good cash position. Especially in sectors like mining, oil and gas exploration, and biotech where abundant cash is needed to support the business until they strike gold or oil, or get FDA approval for a new drug.
- Ideally, increasing revenue and income.
- Good trading volume. We avoid illiquid stocks.
By simply following those very rules, you should ideally be able to generate above-market returns with below market risk.