Value Investing for Beginners
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The first part of value investing is to find a mature and stable company that is managed responsibly that will grow over time and last for years. The second is to establish an entry price that is less than the value of the company.
Characteristics of a Good Company
1)Profitable Business
2)Lots of Loyal Customers
3)Always Ahead of Trends
4)Market Leader
5)Good Growth Potential
In order to learn Value Investing you must first learn how to read Financial Statements and what we learn from them.
Balance Sheet
The balance sheet shows what a company owns and owes. It is used to establish the equity in a company.
Equity=Assets-Liabilities
Terms to Know
Current Assets: are assets that will be used in the next 12 months or less. Examples are perishable food, building materials, petty cash, etc.
Current Liabilities: are liabilities that will be paid in the next 12 months or less. Examples are short term debt, accounts payable, short term loans, etc.
Noncurrent Assets: are assets that cannot be liquidated easily and turned into operating cash. Examples would be office furniture, real estate, cars, etc.
Noncurrent Liabilities: are liabilities that will need to be paid off in a term longer than 12 months. Examples wouldbe long-term loans, auto loans, etc.
In order to be considered a good candidate as an investment we want to see equity growth year over year and debts decreasing over the same time period. We don’t want the company to have a huge debt burden. The debt to equity ratio should be <50%.
Debt-to-Equity Ratio= (Long Term Debt + Short Term Debt)/Equity
Income Statement
The income statement is used to see if the company is actually making money. We want to look at the net profits over the last 10 years and see if it is consistently growing.
The next thing we want to look at is Return on Equity (ROE), this shows us how efficient a business is at using its equity.
ROE=Profit of Current Year/Equity of Previous Year
Loot at the ROE for the previous 10 years, we want to see consistency. Generally speaking a company that has a ROE >15% is an excellent business.
Cash Flow Statement
We want to see consistent growth in Net Profits over the previous 10 years.
Next, look at 10 years of Free Cash Flow
Free Cash Flow=Net Cash from Operating Activities-Capital Expenditures
Capital Expenditures are necessary expenses to maintain current assets.
We want to be positive over the previous 10 years.
Now that we have learned how to get what we need from financial statements for value investing we can look at company valuation to determine our entry prices.
Valuation
We will look at a few different valuation methods to determine a conservative entry price into a stock that will give us the best ability to not lose on an investment.
Net-Net Valuation
We use the Net-Net Valuation method to determine an entry price of a particular stock based off of the value of its assets. This is calculated by first determining the Net Current Asset Value (NVAC) a.k.a. Liquidation Value.
NVAC=Current Assets-Total Liabilities
The next step is determining the NVAC per Share
NVAC/Share=Net Current Assets/# of Outstanding Shares
We want to purchase a stock with a 33% margin of safety below its NVAC/Share value.
Entry Price=NVAC per Share value * .66
Price-to-Book Value
The difference between Price-to-Book Valuation and Net-Net Valuation is Price-to-Book Valuation includes both current and non-current assets instead of just current assets. Net-Net is a more conservative valuation method.
To start we need to determine the Net Asset Value (NAV). Most stock websites will calculate Book Value for you so we need to understand that NAV=Book Value=Equity=Net Worth of Business. You may see these terms used interchangeably. Given this knowledge, this method is easier to implement than Net-Net valuation.
Next, we need to calculate the NAV per Share.
NAV per Share=Equity/# of Outstanding Shares
Calculating the entry price using Price-to-Book Value
Entry Price= NAV per Share * .80
Like Net-Net valuation, this is a good method to use for companies that require a lot of capital or assets to operate like Banks, Insurance Companies and Manufacturers. This method does not work for companies that do not such as tech companies. In this instance we will use P/E Ratio.
P/E Ratio
Unlike the other two valuation methods, the P/E ratio method evaluates companies based on their ability to make money. The P/E ratio shows how many years it would take to break even on your investment at the current earnings rate and stock price. Different industries have different average P/E Ratios to compare to.
A relatively safe position is to buy when the P/E Ratio is 30% less than the companies average P/E Ratio. Calculate the company’s average P/E Ratio for the last 10 years. We can know the price is 30% below the average P/E Ratio by first determining the Earning Per Share (EPS).
EPS=Total Profit/# of Outstanding Shares
Purchase Price= (Average P/E Ratio .70) * EPS
Calculating Dividend Yield
Dividend Yield is the way we evaluate a stock that we invest in for the dividends we receive. To determine if this stock is worth investing in for its dividend we should look at the previous 10 years and see if the company has been paying a consistently increasing dividend.
The dividend yield should be at least 2% higher than the risk-free rate. The risk-free rate is the higher of bond rates or bank deposit rates. We calculate the dividend yield by taking the yearly dividend amount dividend by the stock price.
Example: If a company pays a $.10 dividend per share per year and a share costs $1.00.
.10/1=10%(Dividend Yield)
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