Value investing is buying stocks that are perceived as being worth
more than what you pay for them.[1] [1] Stocks are valued most
commonly by the net tangible assets of the companies they represent,
earnings per share, and dividends they pay. Thus, a value investor
would favor those stocks that have low price/book ratio, low
price/earnings ratio, and high dividend yield.
However, it would be dangerous to go out and buy any stock that meet
these criteria, as a stock that appears cheap may in fact be on the
brink of bankruptcy and not a bargain at all, despite the figures.
Sorting out between the true bargains and the false bargains, or value
traps, is not easy. Here are some things to look for that may help you
to make the distinction with caution.
!! Steps !!
Stay clear from stocks that have dropped in price due to to exposed
corporate fraud. Some recent examples like Enron, Worldcom, and Tyco
have experienced marked drop in prices that make them look like
bargains after their scandals were exposed, but in the end they're
in a relentless trajectory to zero, leaving shareholders with
nothing. Wherever fraud is involved, the figures in the financial
statements that are used to determine value are meaningless, and the
company simply cannot be valued appropriately. Moreover, once a
fraud is discovered, the company tends to have little, if any, value
left that has not already been stolen by corrupt management. Do not
touch stocks of companies involved in corporate fraud with a ten
foot pole!
Avoid companies with high debt or leverage. Debt or leverage is a
double edged sword. In good times, you can make twice as much money
using leverage and borrowing is easy; in bad times, you lose money
twice as fast and the time when you need the money the most is when
creditors start calling you and demanding repayment of the debt.
* For a good margin of safety to make sure a company is able to
satisfy interest payments on its debt, look for companies with at
least two to four times interest coverage (earnings before
interest at least two to four times interest charges). Upper limit
applies to industrial issues, especially cyclical ones; lower
limit applies to more stable incomes such as utilities.
* Remember, a company with no debt can never go bankrupt. On the
other hand, excessive leverage can destroy even a great company.
Avoid companies that have fallen due to outdated products and
services. Blockbuster is a good example: who needs to go to a
physical store to get videos or DVDs when they can be download at
home with the click of mouse? Likewise, newspaper and physical
bookstore businesses have been hurt by the expanding internet.
Outdated products and services often signify that the lost revenues
are probably lost forever, and that a rebound in the stock price is
unlikely.
Be careful of companies facing increasingly stiff competition. Look
at the profit margins (net earnings divided by revenue) of a company
through a period of 5 to 10 years, and also compare to profit
margins of competitors in its industry. If the profit margins are
decreasing through the years, that usually signifies that the
company is unable to pass increasing costs onto its customers due to
competitive prices. If a company is no longer competitive with its
competitors, better to avoid it despite the low valuations.
Be careful of companies in highly regulated industries. High fees
and regulation costs in the U.S., for example, have forced many
companies to relocate their business to other countries like China
or face extinction. Most consumer goods are no longer made in USA.
Payday loans are another example. Making $20 in fees for every $100
loan due in 2-3 weeks is great while it lasts, until the government
caps the maximum interest charges to 36 percent per annum, and the
payday loan companies find themselves unable to generate a profit
anymore given such regulations.
* Bad news I'm afraid... gotta cut dividends Be careful of
investing in stocks that have dropped due to a dividend cut,
especially when the company does not expect to resume dividends
any time soon. Dividend cuts usually means the company has no
earnings to pay out. The price correction following a dividend cut
can be prolonged. Wait till the valuations are really compelling,
such as significant price drops that send the stock to 50 percent
or less of its intrinsic value, before plunging in.
Watch out for missed earnings estimates. Analysts are generally
quite lenient in their estimates and tend to revise their estimates
downward before earning release to allow companies to beat their
estimates and look good. Occasional missed earning estimates with
over reaction in the price is a solid reason to buy on the dip, but
a pattern of missing earning estimates is foreboding.
Look for insider buying. Insiders are in the best positions to know
how much their company is truly worth, and if the stock price is
truly cheap, they will be buying the stock. There is only one reason
why insiders buy: they expect the stock to go up. If you see recent
history of insider buying, it's a safe bet to follow suit. On the
other hand, if you see many insiders selling, it may be an ominous
sign and you should probably keep your hands off.
Check the balance sheet to make sure the company is healthy. One
of the most important thing to look for that that the company
should have current assets greater than current liabilities, to
ensure that it can pay its bills in the short term. A more
stringent test is to calculate the quick net asset by subtracting
inventory (which may be illiquid) and total current liabilities
from current assets. Alternatively, determine the quick current
ratio by dividing (total current assets - inventory) by total
current liabilities, and make sure the ratio is greater than one.
Another measurement of financial health is the debt to equity
ratio, obtained by dividing total liabilities by total equity plus
capital surplus. Debt to equity ratio should preferably be less
than 1; the lower, the better.
!! Video !!
!! Tips !!
* Avoid companies with overly complicated financial reports. If you
cannot understand something, it's usually with good reason. Many
financial advisers could not quite understand Enron's elaborate
financial statements, yet they were not disinclined to recommend
the stock regardless. In the end, they got burnt. Overly
complicated financial reports usually signal corporate fraud
exposure.
* The key to avoiding value traps is to attempt to evaluate whether
the drop in price is temporary or permanent. Always ask: can the
company be as profitable as it has been in the past? A stock that
drops due to a temporary problems, such as poor general economic
conditions, increased interest rates, increased energy or raw
material costs, or a one-time charge for things like a lawsuit
settlement or an oil spill cleanup, will typically bounce back.
* Once you have done your research based on fundamentals, do not
worry about market trends, for no one can time the market with
precision and consistency. Market trends, however, can help you by
producing many bargains in recessions and depressions. When the
general market is crashing due to poor economic news, it is the
best environment for finding true value stocks. Moving averages
are the most reliable in a trending market, and the MACD formula
often gives timely signals. The Monthly MACD gave a sell signal
January 31, 2000 and a buy signal May 31, 2003. If you had used
this formula when the market was crashing, you would not have lost
any money in the dot com meltdown, and would be picked up many
oversold bargains, such as Apple at less than $10 between 2001 and
2003 and is now trading at over $300/share. When the market is
rising due to good economic news, the market is trending, and one
should hold onto one's positions unless the market becomes grossly
overpriced, and no stock in a good company below a price/earning
ratio of 20 or a price/book ratio of 5 can be found.
!! Things You'll Need !!
* Access to corporate financial documents
* Financial news sources
!! Related WikiHows !!
* How to Pick Stocks and Other Investments With Fundamental Analysis
* How to Invest in Stocks
* How to Choose Stocks
* How to Buy Stocks
* How to Find High Yield Stocks
!! Sources And Citations !!
!! Article Tools !!
* Read on wikiHow
*
Links:
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[1] http://bemoreconfident.info/#_note-0
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