There are many strategies you can use when investing in stocks. I am primarily a value investor, which in short means I buy into the value of a great company, when it is for sale at a good price. I do not want to go through the whole history of value investing, as I just want to tell you how I value a company, as you can use that as a guideline once you are reading my blog.
I'm very inspired by Phil Town and his Rule 1 investing. I use the tools from his books, and if you want to read further into them, I encourage you to buy his books and check out his website.
Ok, let us go through this. Once you read my blog post on how I value the companies, you will see I refer to something called "moat" and five different numbers. I will go through them shortly here.
Moat means that a company has a moat that protects their business from other companies. A moat can be many different things for a business, it can be a Brand Moat (consumers trust the brand), Secret Moat (the companies have a patent or trade secret), Toll Moat (a company has exclusive control of a market), Switching Moat (it is such a big part of a consumers life, as it isn't worth to swtich), Price Moat (a company can price a product lower than their competitors).
The five numbers are:
1. Return On Investment (ROIC): It means the rate of return a business makes on the cash it invest in itself every year. With other words it is the amount of money that the business makes each year on the capital it has to invest. A company should have a ROIC of more than 10 % a year om average for the last 10 years.
With the following numbers ideally we would like the growth rates to be above 10 %, however it is more important that the growth is consistent over the years. A company can have a down year but if it does, it is important to investigate the reason why. I know my explanation is quite simplistic, it is because I would like to keep this as short as possible.
2. Sales Growth Rate: Sales is simply the total amount of money the company took from what ever it was selling. So the Sales Growth Rate is how much the sales grow.
3. Earnings Per Share (EPS) Growth Rate: EPS tells us how much the business is profiting per share of ownership. So the EPS Growth Rate is how much the profit per share grows every year.
4. Equity Growth Rate: Equity is what the company would have left if they sold everything, paid all debt and took the money that was left. So the Equity Growth Rate is how much the equity grows every year.
5. Cash Growth Rate: Cash tells us if the company's cash is aligned with the profit, or if the profit is only in paper. The Cash Growth Rate is how much the cash is growing.
Once we have done the above, we need to look into the management of the company in order to determine that it is truly a wonderful company. This is somewhat of a more different exercise, as we can't look up numbers as above. However, what you want to make sure is that the CEO works for its owners and not for them self. You want an CEO who are driven to move the company forward and are not in it for his salary one great example of this was Steve Jobs. If you are more interested in how to determine a good management, I will advice you to read Phil Town's books.
Once we have decided that we want to invest in a company, we want to make sure that we pay the right price. There are three ways you can do so, and once the price hits the highest price of your calculations, you will open a position.
The first way to calculate a price in which we want to open a position is to calculate a fair price of a company (also called sticker price) and demand a margin of safety. Ideally the margin of safety should be 50 %. Meaning if you find a sticker price for a company to be $100, we would ideally buy it for $50. So let us go through how we calculate a sticker price.
In order to do so we need 4 numbers:
1. Current EPS.
2. Estimated future EPS growth rate.
3. Estimated future PE
4. Minimum acceptable rate of return (should always be 15%).
If you want to know how to get those numbers, I will advice you to buy Phil Town's books, as I do not think I should share this information here.
Once you have the numbers it is a pretty easy exercise. You multiply Estimated future EPS growth rate with estimated future PE, divide it with 4 (which equals 15 % for future 10 years stock price) and in the end divide it with 2, if you want a 50 % margin of safety.
The second way to calculate a price is to calculate a cap rate. A cap rate is essentially the rate of return an owner of a company (or stock) gets each year on the purchase price of the company (or stock). Warren Buffett calls this Owner earnings meaning it is the amount of cash that goes into the business each year without it would affect the business operations. This would need to be at least 10 %. And the calculations are as followed:
Net Income - Maintenance Capital Expenditures + Income tax / Outstanding shares x 10 = xx
The third way to calculate a price is called payback time. It just means the number of years it takes to get your purchase back. It shouldn't take more than 8 years to get it back through the compounded growth rate. In order to do so you need the free cash flow from the company, and once you got that, it is quite simple. You just multiply each each years free cash flow by 100 % plus the growth rate, and once you have done it for 8 years, you divide with the outstanding shares and you get the price you want to pay.
All of this was just to give you an idea about the process I use to find and value companies and find a price. I did not go into details, and if you want to read more about this, I would advice you to go to Phil Towns website. He also has calculators there, so you do not have to do all of the calculations yourself, if you don't want to.
Keep in mind that besides my value investing, I also allocate a small part of my portfolio to more riskier stocks with great growth potential.
Due to the current overvaluation of the market, and as I want at least some of my money to work for me, my strategy is a bit different at the time being. I do use value investing, however I have diversified my portfolio more than usual with various stocks with different roles. Some pays dividends while other are used for hedging. I have tried to pick stocks which would be less impacted by the market volatility.