Value Investing For Dummies Cheat Sheet
Regardless of what the bulls and bears say, you can add value investing to your investment strategy if you can identify the truly good businesses that outperform both their competition and the market as a whole. Start studying value investing by understanding how to appraise a business, learning the components of a value analysis, and familiarizing yourself with common scenarios of value investing.
How to Appraise the Value of a Business
Value investing means treating an investment as though you were buying the entire business. If you were indeed buying a business, you’d look for the following:
Income: Profits — and strong positive operating cash flows exceeding capital requirements — are a good thing. A company starting at a loss and banking on future profits is starting in the hole, particularly considering the time value of money. Look for companies that produce more capital than they consume.
Income growth: If income and cash flow are steady but unlikely to grow, there can be value. Without growth, time value depreciates earnings value over time. And competition and declining marketplace acceptance can erode the business. There’s little to make a stock price rise unless the market values the steady income stream incorrectly in the first place. Value investors should ignore the common “growth versus value” paradigm and consider growth part of the value equation.
Productive capital investments: If a company is able to invest additional capital productively — at a greater return than it would get by putting it in the bank — that indicates future value if the capital is available. A company should be able invest capital more productively than you can; otherwise, it makes sense for the company to return the capital to you, and for you to invest the capital elsewhere. If the company doesn’t have productive places to invest but pays you a good return (dividends or share buybacks), the company has value, but growth potential may be in question.
Rising productivity and falling expenses: A good business makes increasingly better use of assets and creates more output per unit of input. Businesses that can do so are likely to generate more income sooner.
Predictability: Generally, a business with a predictable, steady income stream is more valuable than a company that has erratic or cyclical earnings. The erratic company may return as much money in the long run as the steady company, but the uncertainty surrounding the earnings stream requires a higher discount rate or margin of safety because you just don’t know. The higher discount rate reduces value. Look for simple and steady businesses that you understand.
Steady or rising asset values: To the extent that asset values, particularly current assets, are steady or rising, higher returns, if and when paid out to the owners, will ultimately be the result. A company with falling asset values is suspect unless its productivity gains are significant.
Favorable intangibles: Many things can affect or serve as leading indicators of business value. Management effectiveness, market presence, brand strength, customer base, intellectual property, and unique skills and competencies all play a part in driving business value. By nature, these items are hard to quantify but are part of the valuation playing field. Look for companies that do things right in the marketplace.
Components of a Value Analysis
To understand value investing, you need to understand an entity’s intrinsic value, as well as how to analyze strategic financials and compare intangibles. The following table goes into more detail.
|Intrinsic value||Total value of discounted future cash flows||Valuation starting point
Define potential value range
|Intrinsic value model|
|Strategic financials||Analyze key ratios and numbers for profitability, productivity,
capital structure as return-on-equity (ROE) drivers
|Identify potential for maximizing return on equity (ROE)
Evaluate effectiveness of management and business strategies
|Financial statements and ratios
“Strategic Profit Formula”
|Strategic intangibles||Composite sketch of intangibles: market position, brand
strength, supply chain strength, and management
|Judge leading indicators and influencers of profitability,
productivity, and capital structure
|Newswires, trade press
Common Scenarios of Value Investing
To incorporate value investing into your investment strategy, you need to understand how to value stocks and commodities, how to decide when the price is right, and when to make your move. Start your research by looking at the following table, which highlights common scenarios of value investing, loosely sorted by how often you’ll find and use them.
|Growth at a Reasonable Price (GARP)||Companies with a strong and sustainable earnings and cash flow
growth picture or vector (such as international sales) selling at a
reasonable price related to discounted future value
|CarMax, Procter & Gamble, Starbucks (at times), Simpson
|Fire sale||Solid businesses taking a short-term hit but with strong
fundamentals; market downside overdone
|LCA Vision, regional bank stocks (Q4 2007)|
|Asset play||Companies with strong balance sheets and/or undervalued assets
such as real estate; companies with breakup value higher than share
price indicates; companies with some other asset, like a brand name
or patent, that may be undervalued
|Most railroads, timber companies, REITs
|Turnaround||Companies whose fortunes have turned with improved business
strategies, execution, management, marketplace acceptance
|Hewlett-Packard in 2005–6|
|Growth kicker||Companies with a new growth business not previously taken into
account in valuation
|Apple in 2003–4|
|Cyclical plays||Companies emerging from typical cyclical ups and downs with
more sustainable growth and markets
Note: this situation is rare, but some companies do find new