“We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all important and is the only logical way to evaluate the relative attractiveness of investments and businesses.” – Warren Buffett Letter to Shareholders
This section gives you a thought process on how to evaluate investments. Given that the market can swing based off changes in expectation of future cash flows, it can be subjective and there is no way to consistently beat the market, but here are some thought starters on how to evaluate investments.
P/E Multiple – P/E is defined as the Price/Earnings multiple. It is the stock price (per share) in comparison to earnings (per share). You can also think of this as how long it would take for the company to pay back its share price. For example a company with a P/E multiple of 10 would take 10 years to generate enough earnings to payback the stock price. The key assumptions being that their anticipated future earnings is the same or relatively stable to current earnings. When growth companies are in their growth phase and earnings are increasing drastically year over year they will tend to have a much higher Price/Earnings multiple. For context, the current dow industrial P/E multiple is 15.73, and has historically been between 10 – 25.
Debt to Equity Ratio – Debt to Equity is amount of debt (loans) that a company has relative to the amount of equity (value of shares of stock). As the debt to equity ratio rises and the proportion of debt starts to outweigh equity drastically it could be a potential sign of troubles ahead in terms of the ability to repay debt.
Dividend Investing – A dividend is a payment to investors from profits of the company. Each company chooses how much (if any) to pay back to investors. One might think that companies should payback all profits to investors, the flip side is that all profits repaid to investors is money that can not be re-invested into the business. What the company is signaling to investors is that investors can do a better job of investing the money in other endeavors rather than the returns that a company can generate with that money. Usually in industries where profitability is quite stable and growth potential is limited, they will have higher dividend ratio payouts than companies that are going through periods of high growth. I.e. Energy/Telecom as an industry has a higher dividend ratio than Technology. It is worthwhile to consider dividend stocks as part of your portfolio as these companies can generate consistent dividend returns like fixed income.
Understand and Believe in The Business – In order to feel comfortable with investments it’s worthwhile to understand how the business works and also believe in the long term growth and success of the business. Information on the company is found within the 10K / Annual Reports for publicly traded companies. These will paint a rosier picture of the company but are a good way to start understanding how the business works and where senior management believes growth will come from.
Big Brands that You Love – Take a look at the stocks of brands that you love. When companies have a loyal following, they tend to grow at a faster rate than market expectations and this can drive the stock price up. In a nutshell, if you believe that the market has under-estimated a stock, it may be worthwhile to invest in it. Usually folks have a hard time estimating the future cash flows or future potential of a company, especially when it a loyal following.
Historical Stock Price & Volatility – The past will never predict the future, but may be utilized as a data point when it comes to investing. Seeing the historical price and volatility of a stock may provide insight into the future.