Warren Buffett always says that one cannot select the best stocks till you know about it. Suppose you are buying a IT stocks regarding which you have no knowledge (either its nature of business, fundamentals or products) then it is like shooting in dark and hoping to hit a bulls eye. This type of investing is dangerous and shall not be practiced at all. The best investing style is to invest in stocks that you know. In Investing the more information about the company will trigger a better decision regarding stock purchasing. Warren Buffett calls this as investing within your ‘circle of competence’. Invest in stock of companies that you know.
In this article we will see how we can use different methods to do stock valuation.
Stock Valuation Method-1: Fundamental Analysis
This is perhaps the most used method of stock valuation by investors. In doing fundamental analysis of stocks the point under consideration is the capability of the company to ‘generate future income’ for its investors. For all investors whose investment horizon is long term, fundamental analysis of stocks/business is more suitable for them. In an ideal world we can forecast the future incomes by looking at past performances of the company. But this world is dynamic and our stock markets are even more volatile. So needless to say the doing fundamental analysis is not easy. And this is why you will not find lot of followers of fundamental analysis theory. But the fact remains, if you can master the skills of fundamental analysis you will become the master of stock market investments like Warren Buffett. In fundamental analysis the term ‘future income’ means what? For an investor there can be two types of future income (1) income from dividends and (2) income from capital appreciation. So in order to effectively do fundamental analysis of company we shall first forecast the possible dividend disbursements in times to come. Forecasting future market price of stocks is still tougher, but for sure it is linked to companies earnings (EPS), so if we can accurately predict future EPS values, we can forecast market price by using a standard P/E multiple. But believe me it is easier said than done.
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Stock Valuation Method-2: Qualitative Analysis
If you thought that fundamental analysis of stocks asks for a very broad research on companies business then lets give you a more definitive parameters on which you can base your analysis of stock’s valuation. The most important parameter of running a strong business is its top management. The people in this top management are the ones who runs the business with both short-terms and long-term perspective in their vision. The next important parameter to be considered while studying stock valuation is to know how company is generating income/profit. In order to know this, one needs to know about its products, how they are manufactured and sold. Basically what are trying to tell you is to start reading the companies ‘annual reports’ which describes in detail how that company is making money. Reading annual reports (financial statements) is an art, but you can master this art by practicing. Next one shall also study the competition faced by the company in the market. If a company one is competing against is like McDonalds, Microsoft, Apple, Google, Coca Cola etc then long term growth will not be easy. Investors can compare the financial statements of competing companies (available on internet) and see important parameters like growth in sales, growth in profit margin, growth in EPS etc. From these figures it is easy to understand if the company is enjoying competitive advantage or not. The problem of competitiveness becomes even more tough if the competitors brand names are dominant. A combination of a great management, product, brand name and sales/marketing strategy can give any company a huge leverage above its competitors.
Stock Valuation Method-3: Value Investing
Though I would like to call myself as a value investors, but for sure I do not have the skill and mindset for value investing. But one thing I can say with confidence that in last 4/5 years, just by following value investing concepts, I made decent money from stock market and investing in totality. Value investing is far the most effective and easy to apply stock valuation methods of all. Value investing is not just about buying stocks whose price is trading at all time lows. We need to analyze why the stocks are trading so low before buying one. The best way to know this is by analyzing the financial statements of the companies. The idea of value investing is to buy ‘quality companies’ at undervalued price. We cannot buy stocks of any tom dick and harry and feel that we are value investors. If you can buy Google or Coca Cola at undervalued price, then this will be value investing. There are simple rules of value investing which ones applied to a stocks will tell you if this stocks is a ‘quality stock’ or not and whether is available at ‘undervalued prices’ or not. Some quick tips of value investing are:
(1) Always calculate the intrinsic value of stocks,
(2) Buy only those stocks which is trading at 2/3rd of its intrinsic value (margin of safety),
(5) The company should have been able to increase its EPS (in last 5 years) and annual growth rate (CAGR) of more than rate of inflation prevailing in the country.
(4) Market price of stock should not be more than 1.5 times its book value,
(5) One should always avoid companies which are doing business relying on debt. Avoid companies which has debt-equity ratio of more than one,
(6) Earning Yield should be at least close to rate of inflation prevailing in the country
(7) Company should have a consistent of dividend disbursement to its shareholders with current dividend yield close to interest (net of tax) offered by bank fixed deposits
Stock Valuation Method-4: Growth Investing
In principal value investing and growth investing is not very different. But value investing is done with the objective of holding on to stocks for lifetime (as focus is more on dividend earning than on profit booking by selling). But in growth investing stocks are bought with objective of selling them for profits in future. Value investing is more certain form of investing because dividend income is more predictable that future market prices. But trained eyes and good knowledge of stock investing can help investors to identify some quality growth stocks. In growth investing we look at those stocks/companies which has potential of growing faster than other stocks in future. Here also we need to worry about buying stocks at undervalued prices, but not for maximizing dividend income but to maximize future capital appreciation. There some quality companies available in the market which does not distribute dividends to its shareholders, value investors will not consider such companies as their picks. But for growth investors even these companies are interesting if they can show good capital appreciation in times to come. Some key indicators that can highlight if the company is has growth prospects or not is as below:
(1) Investors must check at what rate the companies turnover has grown in last five years. Large Cap stocks will grow slower than mid caps and small cap stocks.
(2) Investors must check at what rate the companies’ EPS has grown in last five years. Ideally it shall be more than 15% per annum. As a rule of thumb, growth investors looks for doubling their capital in five years, means they will need a CAGR of at least 15% per annum.
(3) Investors must check the profit margins (before tax) for last five years. If profit margins are increasing it meaning either managements focus is on cost cutting or company is enjoying good competitive advantage over its competitors.
(4) How well companies is using investors money to run its business. This can be quantified by calculating Return on Equity (ROE). Comparing ROE values of a company with its competitors will give investors a very idea of how well the company is using shareholders funds to manage its business.
Stock Valuation Method-5: Technical Analysis
It will not be wrong to say that technical analysis is layman’s method of stock valuation. Here one need not look into the companies’ financial reports to value stocks, but simply tracking market price movements will give enough insights if the stock is worth buying or not. All above stock valuation methods discussed above like fundamental analysis, value investing, growth investing are suitable for long to medium term investing. But technical analysis is suitable for short term investing only. A very important assumption of technical analysis is that stock price movements is a cyclical movement hence if one carefully looks at stock price chart, they can predict future prices. Two important terms that technical analysts use very commonly in making their predictions, ‘Support & Resistance’. Support is the price level which indicates that there good chances of prices moving up from this level, and resistance is the price level beyond which stock price is not likely to move further up. An investor who follows technical investing will go for a ‘long position’ (means buy and hold till resistance level is reached) in case stock price is at support levels. If the stock price is at resistance levels they will go for ‘short position’. A typical technical charting pattern commonly used by technical investors is called ‘cup and handle’. If stock price is at handle levels then most likely the price of that stock is going to only move-up very soon. In this case investors can go for long position (buy) with expectation of good capital appreciation. Another most used charting patters is called as ‘shoulder and head’. If stocks has been trading in price levels of ‘shoulder and head’ levels then it is most likely that market price is going to fall to low levels very soon. In this case investors can go for short position (sell).
In addition to above there are other different methods of stock valuation concepts available in the market. But I think all those are only hybrids of the above 5 methods. My personal choice of investing style if ‘value investing’, but often I switch between growth and value style as situation demands. I generally do not look at technical’s of stocks except of their 52week highs and lows before buying/selling my holdings. Fundamental and quantitative analysis is the basis of ‘stock valuation’ concepts, if one can master these two skills they can become a champion investor like Warren Buffett.