In investing circles you will often hear the phrase that you have to buy low and sell high to be successful. It doesn't get any simpler than that, and actually executing it can mean the difference between success and failure. The challenge comes in when trying to determine whether the price of the stock is actually cheap or expensive. Is a stock cheap when it costs $20 per share and expensive when it's trading at $200 per share? It really depends on a lot of other factors.
Some people recommend that you study the PE ratio when evaluating whether something is expensive or not. A high PE ration would mean that the company's price if pretty high relative to earning and therefore expensive. Some experts will tell you that you need to look at the return on equity, and if it's not above 10% you shouldn't spend any more time on that stock. High debt to equity ratios are generally a bad thing for value investors and good companies typically have low levels of debt.
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.
The other metrics that go into figuring out the Intrinsic Stock Values include determining the projected free cash flow for the company, which can usually be deduced by looking at the company's recent free cash flow and estimating a future value. That type of information can be obtained from the company's Cash Flow Statements by subtracting Capital Expenditures from Cash from Operating Activities.
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.
Measuring risk can be done by plugin in a discount rate into the discount cash flow model. Risky companies have discount rates over 15% and companies that are not considered risky have rates below 9%. Pick something in that range based on your assessment for the company's risk. To measure market risk you will need to add in a perpetuity growth rate that will either be 2% for declining markets, or 3% for rising markets.
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.
The best way to make sure that you haven't made a mistake is to actually go back and read the financial statements and annual reports for the company you're looking at. Out of all of the things you can do as an investor, there is nothing more impactful than actually reading through those documents. Doing so will ensure you calculate intrinsic values that make sense.
Some people recommend that you study the PE ratio when evaluating whether something is expensive or not. A high PE ration would mean that the company's price if pretty high relative to earning and therefore expensive. Some experts will tell you that you need to look at the return on equity, and if it's not above 10% you shouldn't spend any more time on that stock. High debt to equity ratios are generally a bad thing for value investors and good companies typically have low levels of debt.
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.
The other metrics that go into figuring out the Intrinsic Stock Values include determining the projected free cash flow for the company, which can usually be deduced by looking at the company's recent free cash flow and estimating a future value. That type of information can be obtained from the company's Cash Flow Statements by subtracting Capital Expenditures from Cash from Operating Activities.
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.
Measuring risk can be done by plugin in a discount rate into the discount cash flow model. Risky companies have discount rates over 15% and companies that are not considered risky have rates below 9%. Pick something in that range based on your assessment for the company's risk. To measure market risk you will need to add in a perpetuity growth rate that will either be 2% for declining markets, or 3% for rising markets.
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.
The best way to make sure that you haven't made a mistake is to actually go back and read the financial statements and annual reports for the company you're looking at. Out of all of the things you can do as an investor, there is nothing more impactful than actually reading through those documents. Doing so will ensure you calculate intrinsic values that make sense.
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