• The main focus of fundamental analysis is a company’s intrinsic value
• In quantitative analysis, the worth of a company is all of its future profits summed up together.   This is also known as discounted cash flows.
• Management, business model, brand name and industry are some of the qualitative factors that affect a company’s value.
• Value investors are concerned with the present.  They look to a company that sells stocks lower than the current market price and sell it for a profit.  Growth investors look for companies with future growth potentials.  They look for companies that trade more than their intrinsic value.
• The GARP method is a mixture of value investing and growth investing techniques.  Investors look for companies that are somewhat undervalued in terms of growth potential.
• Income investors look for companies that pay high but sustainable dividend yield.  They are looking for a steady stream of income from their stocks.
• CAN SLIM stands for: current earnings, annual earnings, new changes, supply and demand, leadership in industry, institutional sponsorship, and market direction.  Investors analyze these factors for stock picking using this method.
• The Dogs of the Dow are the top 10 companies in the Dow Jones Industrial average with the highest dividend yield.
• Technical analysis is concerned with past market activity to forecast future price movements.

The Philosophy

John Murphy, technical analysis guru explained the basics of TA in his book “Charting Made Easy”.  Here he outlines the core of technical analysis as well as the tools and underlying theories.

“Chart analysis (also called technical analysis) is the study of market action, using price charts, to forecast future price direction. The cornerstone of the technical philosophy is the belief that all factors that influence market price – fundamental information, political events, natural disasters, and psychological factors – are quickly discounted in market activity. In other words, the impact of these external factors will quickly show up in some form of price movement, either up or down.”

The most important assumptions of TA are:

a) Markets are efficient

b) Prices move in trends

c) History repeats itself

TA Don’ts

Technical analysts don’t care for intrinsic value and other things that fundamental analysts look for.  They usually ignore management style, business models and competition.   TA are more concerned about charts, graphs and trends and usually trade companies they know very little about.

Is TA for long term strategy?

No.  Technical analysts live a very active lifestyle.  They constantly monitor the ups and downs of stock and take action based on these fluctuations.  An investor who uses this strategy can go long or short on a stock depending on what direction the data is moving.

Speed is important to technical analysts.  Whilst value investors have to wait patiently for the market to correct the undervaluation of their company, TA have to decide almost immediately whether to hold or discard stocks using stop-loss-orders to mitigate losses should a company not perform to par.  It takes a lot of trading skill to get in and out of sticky situations like this.

Support & Resistance

Support and resistance are common concepts in the world of technical analysis.  Traders usually buy and sell stocks at these levels because they indicate how well a stock might (or might not) perform.  When TA expect a stock to start decreasing after a decline this is the support level.  Once it begins to increase after a decrease this is the resistance level.  When a stock hits support levels, TA will enter into a long position, while they enter a short position once resistance level strikes.

Picking Stocks With TA

Technical analysts have a whole caboodle of tools to help them pick stocks.  While no one tool is infallible, a TA must interpret these data with subjective process.  Here are some popular examples of chart patterns used by technical analysts for stock picking.

• Cup and Handle

As the name suggest, this chart pattern looks like a cup with a handle.  This is a bull market pattern and the end of the handle indicates is when it is a good time to buy as profits great when the market breaks out at this point.   This is a popular chart as it is very easy to spot.  Here’s what a cup and handle chart looks like:

• Head and Shoulders

No this is not the shampoo. The head and shoulders is considered a bearish pattern and looks like a head with two shoulders, as the name suggests.

Conclusion

Just like any other stock picking strategy, technical analysis relies on different techniques compared to fundamental analysis.  But regardless of the style used, mastering technical analysis takes time, experience and savvy.

That Simple?

Yes.   Investors who follow this strategy reassess the companies in the DJIA every year.  Once the highest yielding companies in terms of dividends are identified, your broker can make changes in your portfolio in accordance to the DJIA list.  You then hold on to these stocks for a year and then repeat the process at the end of the calendar year.  Usually, there will be two or three companies that are dropped from the DJIA so your portfolio will need to be realigned to the 10 stocks.

There have been instances where the Dow has beaten the Dogs, so this is usually a long term investment strategy.

The Premise

In theory, out of favor stocks from the DJIA are still good investments because once the market rebounds, these stocks can be revalued and resold and you can replenish them with other companies that have fallen out of favor.  Companies that make the DJIA are usually solid companies that have solid balance sheets.  They are known to be stable despite market decline.  Because the Dow is known for people who really know what they are doing, you can rest assured that the DJIA list is made up of good strong companies.

The Numbers

The strong point of the Dog of the Dow strategy is its simplicity.  Over the years, the Dogs have outperformed the Dow by an average of 3%.  From 1957-2003 The average rate of return for the Dogs as at 14.3% annually compared to the Dow’s 11%.  During 1973-1996 the Dogs gave returned 20.3% to investors annually while the Dow averaged a measly 15.8%.

Variations

Because it is simple, several clones of the Dogs of the Dow have been formulated.  A variation called Dow 5 includes the 5 Dogs with the lowest per share price.  Dow 4 is the 4 highest price of the Dow 5.  And then there’s the Foolish 4 wherein you choose the same stocks as the Dow 4 but allocates 40% to the lowest priced of these 4 companies and 20% to the three other stocks.  All of these variations aim to refine it, to make it simpler and to make it yield higher results.

These variations were developed from old data or back-testing.  There is no way of knowing that the Dogs will outperform the Dow every year.

Before you go out and apply these strategies, remember that while picking high yielding stocks makes sense, picking strictly on price is odd.  Share price is relative and a company can split its shares and still be worth the same amount.  They will simply have twice as many shares as before with half the share price.  With this kind of strategy, there are more questions rather than answers.

Not Certain

Remember that this strategy, is not 100% fool-proof.  It assumes that the same circumstance that happened during the mid 20^th century will repeat itself during the 21^st.  If this is true, then the Dogs will give investors an average of 3% return compared to the Dow.  But again, this is not guaranteed.

Conclusion

The Dogs of the Dow strategy is very simple.  You pick the top 10 highest yielding stocks off the top 30 list of the DJIA and weigh your portfolio equally among them.  Adjust your portfolio annually and expect a 3% rate of return per year should the Dogs outperform the Dow.  This is if history repeats itself.

It is actually an acronym for a very effective investment strategy.  It pays heed to a company’s tangible factors such as earnings while at the same time looking into its intangibles like strength and ideas.  Let us take a look at the seven components of CAN SLIM

C = Current Earnings

O’Neil states that investors should look for a stock that has earnings per share (EPS) in the most recent quarter that has grown on a yearly basis.

• How much growth? – O’Neil suggests 18-20%.  Although this is just a rule of the thumb, there are performers which range on 50%.
• Earnings should be examined carefully -  A good investor should know how to recognize low quality earning figures. Because companies can manipulate their figures, an investor must be prepared to do some investigating and learn to look past the numbers companies put forth.

Once you get a fair idea of the quality of a company’s EPS, look to others in the same industry.   A solid growth in the industry can indicate that the industry is thriving.

A = Annual Growth

CAN SLIM indicates that a company should have good annual growth over the last five years.

• How much is annual growth? – Something within the 25-50% range is ideal.

Wal-Mart for example is a company that has good annual growth that preceded a large increase in stock prices.

Current earnings and annual growth are some of the fundamental steps in quantitative analysis.  They are usually a good basis for a good stock pick.

N = New

For O’Neil, a company that has undergone changes necessary in order to move forward.  Whether it be new management, new equipment or new policies; change necessary for a company to become successful.

Take McDonald’s for example.  The franchise strategy enabled its 1100% growth during 1967-1971!  This is just one example of a company that employed change and was able to reward its shareholders along the way.

O’Neil says that it is human nature to steer away from stocks with new price highs. People are always afraid that a company at new highs will have to trade down from this level. However,   historical data  indicates that stocks that have just reached new highs often continue on an upward trend to even higher levels, according to O’Neil.

S = Supply & Demand

Supply and demand affect all market activities.  If all things were equal, it is easier for a small firm to show outstanding gains.  This is because large companies have more demand compared to small companies and will require more to demonstrate the same gains.

Large investors also lack liquidity which restricts them to only buying large cap blue chip companies.  This leaves them at a disadvantage which small individual investors can take advantage of.  If the stock market capitalization is smaller, the large transactions the institutional investors make can affect share price because of supply and demand.

In his study, O’Neil found that 95% of the companies displaying the largest gains in share price had fewer than 25 million shares outstanding when the gains were realized.

L= Leader or Laggard

In the stock market, there are those who lead and give good returns to their investment and then there are those who lag behind and provide mediocre returns of investment.  You need to separate these two.

• Relative Price Strength -  O’Neil suggests looking for stock with that has a relative price strength of at least 70, though the ideal is in the 80-90 range.
• Sympathy and laggards – Don’t let your emotions make your picks.  Cheap stocks are cheap for a reason.

I = Institutional sponsorship

A stock worth investing in should have at least 3-10 institutional owners.  This is based on the idea that a company without institutional sponsorship would have passed over the thousands of institutional money managers.  However, be wary of stocks with too many owners.  Any bad news could trigger a spiraling sell-off.

M = Market Direction

When picking stocks, identify what market you are in.  Are you in a bear or bull market.  Not knowing what market you are in could mean that you might be investing against the current market trend.

• Daily Prices and Volume – keep track of market conditions by watching the daily prices and volume movements of stocks.  Employ technical analysis tools when needed especially when determining trends.

The CAN SLIM Criteria:

C = Current quarterly earnings per share – Earnings is up at least 18-20%.

A = Annual earnings per share – Meaningful growth for the last five years.

N = New things – Buy companies with new products, new management, or significant new changes in industry conditions. Forget about cheap stocks; they are cheap for a reason.

S = Shares outstanding – Preferably a small and reasonable number. CAN SLIM investors don’t opt for older companies with a large capitalization.

L = Leaders – Buy market leaders, not laggards.

I = Institutional sponsorship - Buy stocks with at least a few institutional sponsors who have recent records that are better-than-average.

M = General market – The market will have the final word whether you win or lose. Learn how to recognize the market’s overall current direction. Interpret the general market price and volume changes and action of the individual market leaders.

Conclusion

CAN SLIM incorporates all the different criteria of the different strategies involved in stock picking.  It provides clear guidelines when picking stocks.   It is a combination of value, growth, fundamental and technical analysis.

The Dividends

Income investors usually look towards established companies.  These are old, established and reputable.  They have very little room for higher levels of growth and are not in industries that are rapidly expanding.  So instead of reinvesting retained earnings on the company, they pay out dividends to shareholders instead as a means to provide a return.

Dividend Yield

Income investment does not automatically mean that you invest in the company that pays the highest dividend.  You instead take a look at the dividend yield which is the annual dividend per share by share price.  This gauges the actual return a dividend gives the owner of the stock.  Example, a company has with a share price of $100 has a $6 dividend share and a 6% dividend yield or a 6% return on the dividend.  Average dividend yield of companies in the S&P500 is 2-3%.

However, a 2-3% return is not enough for income investors.  They are looking for companies that provide at least a 5% return on their investment.  This means that if a person invests $1M his investment would yield (before taxes) $50,000-$60,000.   The principle behind this strategy is simple: find good companies with high dividend yield and receive a steady stream of income over the years.

Another thing to consider is a company’s dividend policy.  Try to determine whether a company can sustain their dividend yields for the years to come.  If a company suddenly increases the rate of dividends over a short period of time, this might be too optimistic.  A good rule of the thumb:  the longer a company has been paying good dividend, the more likely it will continue to do so.

Johnson & Johnson for example have been paying great dividends and increasing dividend rate over the years.  From 1963-2004, they have been steadily increasing their dividends each year.  If you bought the stock in 1963, your dividend shares would have grown 12% yearly.  In 30 years it would have reached a 48% return on your initial shares!

Critics of the income investing technique say that this strategy is too conservative.

The Downside of Dividends

Dividends aren’t everything.  A high dividend does not mean it’s a good company.  Because dividends come from the company’s net income, it could result to lower retained earnings.  Problem usually develops when reinvesting that money would have been better compared to paying higher dividends.

Income investing is a good stock screener when you want to look for companies with good dividend yield.  Investing on these companies are good especially if they have provide good and sustainable dividend yield.  This is why investors should analyze a company’s fundamentals thoroughly.

Also, dividend yields do not equal low risk.  Risk is still involved especially when dealing with high dividend yields.  This risk can be minimized by picking solid companies.

Dividend yields are also taxable.  They have the same rate as your salary. Therefore these are taxed higher than capital gains which can make your final cut a bit lower than originally expected.

GARP

GARP method looks for companies that are somewhat undervalued but has a solid growth potential at the same time.

Even though GARP uses a hybrid technique from both value and growth investing, it uses a set of criterion that help investors identify potential stocks to buy.  Some critics say that GARP-ers are on the fence when it comes to picking stocks or that their portfolio is a mixture of companies that have value and growth.  This is not true because investors who use GARP identify stocks that have neither growth nor value but have a combination of both.

Who Uses GARP?

Peter Lynch, who is perhaps better known as the world’s best fund manager uses GARP.  He wrote “One Up on Wall Street” and “Learn to Earn”.

The Hybrid Characteristics

GARP investors are concerned about the growth prospects of a company.  They like positive projections for the future.  But unlike their pure growth investing cousins, GARP investors don’t like overly high projections.  They see anything above the 25-50% range as high risk.  They prefer the lower, yet safer 10-20% growth rates.  However, like growth investors, they pay close attention to ROE. A high ROE in relation to industry levels means the company is solid.

Because of the different criteria investors have when using GARP, preferences and picking style is usually customized to suit the investor.  Because investors need to exercise subjectivity when using GARP, investors must rely on their own personal interpretation of a company and use their own judgment.

P/E ratio is often used to pick good companies.  While growth investors look for companies with high P/E ratio, GARP-ers see this as too risky.  They will usually settle for companies within the 15-25 range. Although, this is again subject to an investor’s personal tastes.

Aside from preferring low P/E ratio, they also like companies with low price-to-book ratio.  They prefer P/B to below industry averages.  The idea is that GARP-ers are usually more concerned about present valuations.

The Numbers

What numbers do GARP investors look for in a company?

The PEG Ratio

This is the most important measure to a GARP investor.  Preferably, it should be no higher than one and closest to 0.5.  PEG gauges the balance between a stock’s growth potential and value.

Example, Company X has a P/E = 19 with earnings growth at 30%.  Which means that Company X has a PEG of 0.63 (19/30=0.63).  Good by GARP standards.

Company Y on the other hand has P/E = 11 and growth at 20%.  Its PEG is at .55.  Although it has slower growth compared to Company X, Company Y currently has a better trading price.  Meaning, even though Company X has higher growth potential, it is also overpriced.  GARP demands that a company should have solid growth, but also states that said growth should be valued at a reasonable price.

GARP at Work

Because GARP-ers use a combination of value and growth, the returns an investor experiences are very different from those who use purely value or growth investing.  Example, during a bull market, a growth strategy would be more favorable and returns for the investor would be unbeatable.  During the dotcom boom, neither investor could compete but if the market did turn, a GARP-er would be less likely to be out of pocket.  GARP investors do better in a bearish market because it uses both value and growth strategies.

Conclusion

Mastering both strategies is a must if you want to become a GARP investor.  A novice venturing into GARP world would find himself buying mediocre stocks instead of good GARP companies.  However, many expert GARP-ers have proven that taking the time to master both techniques pays off handsomely in the end.

Growth VS Value

Let’s compare growth investing to value investing to better understand the latter.  Value investing is focused on the current.  It looks for companies that trade below their actual value.  Growth investors, are the opposite, they look towards the future value or potential of a company.  Its current value is not an issue.  Growth investors look for companies that trade higher than their intrinsic value.  For them, they believe that the company’s worth will grow and will therefore exceed their current prices.

Growth investors look at young companies and how much they grow compared to others.  In theory, a young company’s rapid growth translates to more profits and revenue which in turn means an increase in their stock price.  Growth investors look towards the new technology industry. Profits are realized through capital gains and not dividends.

Formula

Growth investors do not rely on a formula for their stock picking.  They are more concerned about a company’s future growth potential.  Picking growth stocks is usually a combination of individual interpretation and judgment.  Investors look at a company’s past performance in relation to the industry’s performance and this usually serves as a basic guideline for growth investors.

NAIC

The National Association of Investors Corporation (NAIC) teaches growth investment.  They teach investors how to invest wisely. Here are some of their guidelines in picking growth stocks:

1.    Strong Historical Earnings Growth

Has the company been growing in the past?  According to the NAIC, this should be the first question a growth investor asks.  if the company displays good growth over the last 10 year period, then it is likely to do so over the next 5-10 years.

2.    Strong forward earnings growth

The NAIC projects that a growth of 10-12% is good but 15% or more is ideal.  The big problem however is that these figures are usually estimates.  So before trusting an estimate, an investor should first look into its credibility.  This requires knowledge in the different growth rates of companies in different industries.

3.    Is management controlling cost and revenue?

Look at  a company’s pre-tax profit margin.  High revenue growth is good but if EPS does not increase proportionately, this is probably due to low profit margin.

By comparing past profit margins an investor can have a good gauge whether or not management is controlling cost and revenue and profit margin.  A good rule of the thumb: companies that exceed their previous 5 years pretax profit margin as well as those in the industry are good buys.

4.    Can management operate the business efficiently?

Compare ROE or return on equity.  Efficient use of assets should be reflected in a solidly increasing ROE.   Take a look at the past 5 years’ ROE and compare to the industry.

5.    Can the stock double in 5 years?

If a stock cannot double in 5 years, then this is not a growth stock.  Remember that growth investors look to 15% growth per annum, which means a doubling in price in five years.

Conclusion

Growth investors are concerned with, obviously, growth.  They look for a company’s potential to grow and expand.  This ensures that the company pays off in the future.

Value investors look for companies that are mistakenly undervalued by the market.  They look for stocks with strong fundamentals such as earnings, dividends, book value and cash flow.  These companies are sometimes sold at bargain prices despite their quality.  Value investors see potential in these stocks and waits for the market to correct the valuation of these stocks.

Value & Quality

Value investors look for bargain prices but don’t just buy any stock that is cheap.  Value investors have to do a lot of research to make sure that they get a company with quality and potential and not just “junk”.

It is important to understand the difference between a value company and a company that is in decline. For example, Company A sells its stock for $25 per share and then suddenly drops at $10 per share.  This decline does not automatically mean that it is a good bargain.  Remember that there are a lot of factors which could affect a company’s market price.  In order for a company to be a good bargain,  a company must have fundamental worth healthy enough to be worth more than its intrinsic value. Value investing is about intrinsic value and not historic price.

To take a look at value investing, take a look at Warren buffet.  In 1967 his company Berkshire Hathaway was trading at $12 and at 2002 it was at 70,900!  This is real value investing!

Buying A Business Not Stock

For value investors, they are buying a business not stock.  When they trade, they see it as becoming the owner of a quality company.  They like to pay more attention to the worth of an underlying asset.  They don’t see volatility and price fluctuations to be a factor in the value of the business in the long run.

Contradictions

Value investors usually do not pay heed to the volatility of the stock market.  The effective market hypothesis (EMH) states that if all prices are reflecting all relevant information, then they are already showing the intrinsic value of companies.  For value investors, the opposite of EMH is true.  They look for time so inefficiency where the market mistakenly valuates a stock.

They disagree that in a time of high volatility or beta, a drop in stock prices mean that Armageddon is upon us.  Volatility does not mean that a stock is automatically risky.  If a company has an intrinsic value of $20 and trades at $15, this could potentially be a good bargain.  If it drops to $10 per share then the company is experiencing an increase in beta therefore, investors would see this stock as high risk.  But for value investors, they would see the decline as an even better bargain, therefore the lower the risk.  Volatile market conditions do not scare off value investors. In fact, they see this as a good thing.

Screening for Value Stocks

Here are some of the qualities of value stocks:

Qualitative aspects

• Where are value stocks found? – Value stocks can be found trading in Nasdaq, NYSE, AMEX, etc.  They are everywhere.
• Which industries are value stocks located? – Just about any industry.
• In what industry are value stocks most often found? – They can mostly be found in industries that have recently experienced hard times.  They can also be found in industries that are facing market overreaction due to a piece of news.
• Can a value company be one of those companies that have experienced new lows?  – Yes.  Remember we are looking for cheap.  However, its “cheapness” may not reflect its intrinsic value.

Her are the number values investors use for picking stocks:

• Share price should be not more than two-thirds of its intrinsic worth.
• Find companies with P/E ratios at the lowest 10% of all equity securities.
• The PEG ratio should be less than one.
• Stock price should be no more than tangible book value.
• Debt should not be more than equity (i.e. D/E ratio < 1).
• Current assets should be twice of current liabilities.
• Dividend yield should be at least two-thirds of the long-term AAA bond yield.
• Earnings growth should be at least 7% per year and compounded over the last 10 years.

P/E and PEG Ratios

Value investing is not just about P/E and PEG ratios even though undervalued stocks reflect a low P/E ratio.  This is just a way to compare companies in the same industry.  Example, if a technology company has a PE of 20, a company that trades at 15 should start to ring some bells for value investors.

PEG ratio is used to calculate a company’s intrinsic value.  If a company’s peg ratio is less than one, then it is a considered to be undervalued.

Net-Net

The net-net method states that if a company trades at 2/3 of its current assets, then no other methods are necessary.  Why?  Because if a company trades at this level then you are basically getting all its permanent assets including the intangible ones for free! Unfortunately, this sort of company is a rare find.

Margin Of Safety

Everybody needs a margin of safety, including value investors.  Think of it this way, if you were setting up a fireworks display you calculate that staying 100 feet away from the explosion is safe. But just to make sure, you stand 125 feet away from the display.  This is your margin of safety.

In value investing, it is simply leaving room for error in your calculation for the intrinsic value.  If a value investor calculates a company’s intrinsic value to be at $30 per share, he adjusts his computation and pegs the price at $26 per share.  If the intrinsic value of the company turned out to be lower than previously calculated, then the investor would be saved from paying too much from the stock.

Conclusion

Value investing compared to other styles may be boring to most investors because it relies on a tight screening process.

Management

The core of every business is people, in this case: management.   These are the people who make or break decisions for the company.  To see whether or not a company has a strong management team or not, one only needs to look at the five W’s:  who, where, what, when and why.

Research plays an important role in picking good companies to invest in.  Find out who the CEO, CFO. COO and CIO are.  These people are the big decision makers in the company.  Where did they come from?  Do they have good education and employment background?  Are they qualified to run the company?  Do they have the necessary know how in order to keep the company in good standing?  Are they capable of the job?

Once you know these then find out what their management philosophies are.  Ask yourself what style of management they follow.  Some people like transparency in business dealings, other prefer the “old school style” and others like to be eclectic in their management style.  Then ask yourself if you like their style of management, if you believe that this style will work for the good of the company and if you agree with this philosophy.

After you’ve gotten to know them a bit, find out when these people took over the company.  A long tenure could mean that the stockholders and its board of directors like the way this team has handled a company thus far.  However, tenure is not all there is to it.  A new team does not always mean that the company is in dire straits.  In the case of Chrysler, Lee Iacocca was brought in as CEO during the brink of the company’s bankruptcy to renew and rejuvenate Chrysler’s status as a major player in the Auto Industry.

Lastly, ask yourself why these people have become managers.  Do they have the qualities you look for in a good leader?  Was he hired because of past achievements or because of familial ties?

How Does the Company Make Money?

To further analyze a company’s qualitative factors, know its products and services.  In MBA speak it would be “What is the company’s business model”?  However, most people would simply ask “how does it make money”?

Knowing what a company does to generate revenue is an important factor in deciding whether or not it is a good stock to buy.   People will sometimes brag about the profitability of a business without even understanding why a company is profitable, or what it sells in the first place.  Take for example the dotcom fallout during the late 90′s.  A lot of people were buying stock without even understanding what these companies sell or do.  This is called herd mentality.  People simply bought stock because of the meteoric rise of dotcom companies and the expected growth potential which in turn led to a market crash.

The Competition

Aside from looking into the company itself, take a look at the characteristics of the industry.  Is there room to grow in that industry?  A so-so company can reap great rewards in a great industry compared to a so-so company in a bad industry.  Determine the demand for that industry is growing or declining.

Market share also plays a big role in good investment.  Take for example Microsoft.  They are the Goliath of the operating system industry.  In the stock market world, David would have a hard time taking Goliath down as Microsoft can take advantage of the economies of scale.

Generally speaking, the harder it is to enter the industry, the better it is for the investor.  Look at it this way: opening a restaurant entails small capital and minimal skill, which is why we have a lot of restaurants all over the world.  Compare that to opening a pharmaceutical company or an automobile factory, you would need government clearances, highly skilled management and work force, huge capital expenditures, etc.   The harder it is to compete in the industry, the better it is for existing businesses.

The Brand

A good brand name reflects on years of good marketing, sound management and years of product development.  Take for example Coca-Cola. It is the world’s most recognized brand.  Analysts estimate the brand name alone to be worth in the billions of dollars!   For companies like Procter & Gamble, it pays to have dependable brand names like Tide, Pampers and Head and Shoulders because having a diversity of brands minimizes the risk to your portfolio since the good performing brands would compensate for the under performers.

However, it would be wise to stay away from brands that revolve around one person.  A case in point would be Martha Stewart Omnimedia.  Stewart’s legal problems hindered the company’s share performance which had nothing to do with company operations.

Don’t Over-Complicate

You don’t need degrees in Finance to be able to pick out the next hot stock in the Stock Market.   During the 1970′s Hanes marketed L’eggs a brand of pantyhose packaged inside colorful little eggs.  They were placed next to the candy bars, soda and gum near the check out counter since R&D discovered that women frequented the grocery aisles 12 more times compared to where pantyhose is normally displayed.  Their marketing paid off and L’eggs became the second highest selling consumer product during the 70′s.

In his book “One Up on Wall Street” by Peter Lynch, he discussed the time his wife drew his attention to this test marketing by Hanes.  Most women could easily see the convenience of this product and one of them was Lynch’s wife.  Thanks to Mrs. Lynch and a little more research, he was able to turn his investment in Hanes as a solid earner for Fidelity, while some of the Wall Street big boys missed out on the profits.

The point is, not all Wall Street traders have all the info on all the most profitable stocks in the market.  The Average Joe can also make it big on Wall Street.  Sometimes, you just need to dig a little deeper and do more research and who knows, you might bump into the next Hanes.

Conclusion

A company is more than its numbers and figures.   You also need to look at other factors that affect a company’s performance in order to figure out its qualitative value.  In order to make a sound investment, looking at the sales and earnings as well as looking beyond the figures is probably one of the most effective methods of evaluating a potential investment.

The Theory

If you want to find out whether or not that stock is a good buy, you simply analyze a company’s fundamentals by finding the stock’s intrinsic value.  How much do you really think the stock is actually worth compared to how much its market value is?  If your estimated value is greater than the market value, then it would make sense to buy that stock.

There are a number of ways of computing for a company’s intrinsic value.  Basically, you just add up a company’s future profits and discount this to the time value of money.  How much do you think $1 is worth today compared to the $1 you receive next year?

We equate intrinsic value to future profits because a business provides value to its owners.  For example, you own a small business.  Its worth to you is the money you can take from it year after year once you have deducted expenses.  The fundamentals of a business is profits – revenue less expense. This is where we get the intrinsic value of a business.

Greater Fool Theory

Now that we know what intrinsic value is, you might be asking why the stock market is so volatile.  Why would stock prices fluctuate if a company’s intrinsic value does not fluctuate?  This is called the Greater Fool Theory and one of its assumptions is that people are rational, but who would buy stock in a company greater than its market value?

Fact is people do not see stocks as discounted cash flows but as a means of trading.  Who cares how much a stock is actually worth if there’s somebody –a.k.a. the investor or in this case, the fool -  who’s willing to buy it at a much greater price than the one you originally paid for?   The basics of investing in the stock market lies speculating how much profit you can gain from the sale of a stock not on a company’s intrinsic value.

There has been great debate as to which is the better way of picking stocks:  following the fundamentals or observing the trends.  Investors who go with the trend and observe its tendencies rely on technical analysis to guide them on their stock picking while fundamental investors rely on speculation.  So, which is the better technique?  The answer is neither.  Any stock picking strategy will have its own pros and cons.  In this case, technical analysis is generally thought of as a short term strategy while fundamental analysis is for long term goals.

Putting Theory to Practice

As mentioned above, investors need to discount cash flows to predict the future intrinsic value of a company.  Doing this in theory is easy but doing it in actual practice is hard.  There are a lot of factors that can affect a company in the future.  How do you predict profit ten years from now considering how hard it is to predict profits this year?  What if the company closes?  What if it is sold?  All of these uncertainties have given rise to a number of models in predicting a company’s intrinsic value.  But not matter how “perfect” a model may seem, they are still vulnerable to the future’s uncertainty.

When you predict this far into the future, problem arises with how to account for the different rates a company grows as each year passes.  This is why this table has two parts.  The first part is for determining the discounted future cash flows of a company over the next five years while the second table computes for the “residual value” or the sum of the future cash flows from year 6 to 10.

For this example, it is assumed that the company grows by 15% for the first five years and then by 5% for the remaining five.  In order to determine the present value (PV), the cash flow of the first five years is added together and discounted to year zero or the present.  After the PV for the first 5 years is calculated we move to part two or determining the company’s cash flow for the remaining 5 years where growth is projected at 5%.  To get the intrinsic value of a company, the cash flows of the company from year five are added together and discounted to year zero.  It is then added to the PV of the cash flow values of years one through five.  If the estimate is higher than the current market value of the company, then it may be a good buy.

Below are the notes for the above model:

1.    Prior-year cash flow – This is amount is theoretical. It is the total profits that the shareholders could get from the company in the previous year.

2.    Growth rate – The rate in which the earnings is expected to grow over the next five years.

3.    Cash flow – If all the company’s earnings were distributed to the shareholders, this would be the theoretical amount they would get.

4.    Discount factor – The factor used to determine the present value (PV) of the cash flow.

5.    Discount per year – This is computed as cash flow multiplied by the discount factor.

6.    Cash flow in year five – The projected amount the company could distribute to the shareholders on the fifth year.

7.    Growth rate – The growth rate starting on the sixth year and onwards.

8.    Cash flow in year six – The projected amount the company could distribute to the shareholders in the sixth year.

9.    Capitalization Rate – This is the denominator for the discount rate in the formula for a constantly growing perpetuity.

10.  Value at the end of year five – Value of the company in five years.

11.  Discount factor at the end of year five – The discount factor that converts the value of the company on the fifth year into the present value.

12.  PV of residual value – The present value of the firm no the fifth year.

What we have is a general view of cash flow compromises and sadly, there is no easy of measuring it.   A company’s cash flow to its shareholders is paid through dividends.  The Dividend Discount Model values a company’s future dividends. However, not all companies pay dividends and there are even some who do not pay dividends at all.  When this happens valuation can be done by analyzing net income, free cash flow or EBITDA and other financial measures.  They all have their advantages and disadvantages. The point is that no matter which method is used, the theory in finding the intrinsic value is the all the same.