Monday, August 13, 2012

Modern Investing Practices

By Malone Richards


Fundamental analysis is the practice of analyzing stocks to determine their intrinsic value. Unlike technical investing, value investing relies heavily on looking at the health of the company itself. It is a long term strategy that is rooted in the belief that companies that generate consistent free cash flow will continue to grow and as a result will have rising stock prices. The key to becoming a successful value investor is to research the company by assessing its debt levels, return on equity, cash left over after subtracting capital expenditures from operating activities, and the general health of its balance sheet, cash flow statement and income statement.

Some investors will tell you to look at the Price Earnings ratio and if the PE is low then you would deduce that the stock is cheap because the company has high earnings relative to its price. Other investors will focus on the Return on Equity metric and tell you that the ROE needs to be over 10%. Low levels of debt and a high rate of sales are also good qualities for companies to have. The question to answer is really what should the actual price that a stock is trading at actually be?

If you want to be an effective value investor you should screen stocks as the first and most important step to make the research part manageable. This should include eliminating companies that don't have earnings, that have high debt-to-equity, low return-on-equity, and companies that don't have consistent positive free cash flow.

There are tools like discounted cash flow models that allow you to asses the intrinsic value of companies. Free cash flow is actually a calculation of the difference between capital expenses and cash flow from operations that you can lookup in the statement of cash flows in the annual reports. Yahoo! Finance and Google finance are good resources for this type of information.

There have been many studies that have shown that value investing works, but many investors are mezmorized by the promise of stocks that grow by 100% overnight. There is nothing more exciting that having your money double in no time at all, but the reality is that sound investing is often slow, consistent, and for lack of a better word, boring. It is those investors with discipline to stick to proven strategies over the long term that will be rewarded in the end.




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