As a dividend growth investor, my main purpose is to invest in stocks paying growing dividends over time. To protect my capital from market crashes and others business risks, I try to buy stocks with a margin of safety.
This means that I try to buy stocks when they are undervalued or at least if the company is truly amazing, when its price is fairly valued.
In order to do this, I need tools to properly value companies.
Intrinsic value is just that. As an investor, you estimate what the real true value of the stock is and you compare your estimation with the market’s stock price.
If the price is under my estimated value price I buy the stock. If not, I wait until market price and value matches or until it gives me a margin of safety.
Benjamin Graham, one of Warren Buffett’s most important mentors, used to say :
“Price is what you pay, value is what you get.”
Known as the father of value investing, Benjamin Graham used to buy stocks when a margin of safety of 25-30% existed.
Warren Buffett, his most known follower, realized over time that it often gives better results to invest in fairly valued stocks with a wide moat vs investing in ordinary companies selling at a great discount.
It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.
I tend to believe that Warren Buffett is right. Wide moat stocks have better return on equity, make more money, have better competitive advantage that help them consistently increase their market shares.
Tools to evaluate the value of a stock
Evaluating the value of a stock is an art. Two analysts could evaluate the same stock and come up with widely different numbers.
That is why Warren Buffett recommend people to invest only in business they understand. If you can’t understand the business model, how it’s making money and understand its competitive advantage and the risks involved than stay away.
He also recommends to avoid businesses who have to resolve complex problems to make money. It is in fact a lot easier to calculate the value of a stock like McDonald’s who’s business is easy to understand and highly predictable than the future prospect of the maker of a great popular app like Candy Crush. I think that Candy crush is a fad. I might be dead wrong. But if I’m right, this means that they will have to create the next addictive game to continue making the same money over time… Not an easy one…
Dividend and value investors use many ratios and tools to estimate if a stock is undervalued, overvalued or fairly valued.
Some like to use the P/E ratio. In general, a P/E ratio over 15 or 20 is considered high. But this ratio must also be compared with the industry and sector and with the five years and ten years averages to help see what the tendency is.
Others are also using the price/book ratio, price/sales, price/free cashflow and price/revenue and compare them to the industry, the competitors and 5 and 10 years averages.
Most investor will use a wide-set of ratios to have a better idea.
Then, most investors will also use tools like the discounted cash flow calculator, the dividend discount model and the graham calculator to estimate the value of a stock based on its earnings and projected earnings growth.
MoneyChimp has a great set of tools to help investors calculate the intrinsic value of stocks. If you want to know more, I suggest you take a look there. They already wrote great tutorials about the subject.
How do you value stocks? Do you use calculators? How do you base your buying decisions?
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