Value Based Investing – How to Buy Cheap Stocks

[YP Investors]

Warren Buffett has made millions from investing and is one of the wealthiest people in America. The cornerstone to Warren Buffett’s success is value investing using fundamental analysis. Warren’s key to making large amounts in the stock market is to buy into companies that are cheap. He and many others have learned this from Benjamin Grahams book “The Intelligent Investor.”

Benjamin Graham was not only the author of Warren’s favorite books “The Intelligent Investor” and “Security Analysis” but he was also Warren’s professor at Columbia University. Needless to say, he is a genius when it comes investing.

Graham was a pioneer of value investing and this strategy is what lead to Warrens riches. It’s very simple, you never buy into overpriced stocks or bonds. This is the key, not buying into stocks that end up big losers, or even moderate losers for that matter. For every 50% decline you have to gain back 100%, and typically it takes more time to gain than to lose. Another way to look at this is if you gain 50% in a year, which is an exceptional return for 1 year, and then lose 33% you are right back where you started.

The massive destruction caused by losses is why it is so important to buy into a security (Stock, Bond, ETF, etc.) when it is cheap.

So what is a cheap company/security? How do I know it is cheap?
The answer to these questions is not binary, and there are a number of factors that come into play when value investing. Even if a security is cheap, there are qualitative factors you must consider including the future of the company and the current management. Just because a company has been earning a certain amount does not guarantee it will continue in the future especially if upper management is changed.

Despite some of the tough qualitative factors to identify, there are a number of quantitative numbers that we can use to determine if a security is cheap!

Let’s start with Book Value. Book Value is also known as net asset value, balance sheet value, tangible asset value, and net worth. This is the total value of a company’s financial and physical assets minus its liabilities, then take this number and divide it by the total number of shares outstanding and you have book value per share. Graham states an Intelligent Investor should not buy into companies unless the price is a max of 1/3 above the book value. For example, if the book value of a stock was $100 per share then the Stock/Security price cannot be higher than $133 for it to be considered cheap by Grahams rules.

Important! Buying a security based on Book Value alone is not enough to be successful, let alone an intelligent value investor. One must also demand a satisfactory P/E Ratio, a strong financial position, and the ability to maintain earnings in the future.

What is a satisfactory P/E Ratio?
In Graham’s book Security Analysis he suggests not buying a security if it’s P/E ratio is over 20. This is yet again only one indicator of a satisfactory P/E ratio. Graham also suggests that the security be lower than usual in price and in P/E ratio than its history of at least 10 years. This may be shocking and you may think there are no stocks left to look at! In reality there are plenty of stocks that can satisfy these requirements and this is one of the key filters that can create the Warren Buffetts’ of the world.

A company in A Strong Financial Position is one which is not over-leveraged with too much debt including loans, large overhead, bond and preferred stock debt, etc. You want to know this company can survive possible setbacks including a bear market without defaulting and going bankrupt.

Finally, to find out if a company can Maintain Future Earnings Graham suggests looking at the past. Looking far enough into the past can give an accurate idea of the future. A company is likely to maintain future earnings if the company has had reasonable stability of its past earnings for at least 10 years. This amount of historical earnings consistency will give a great representation of what the future earnings should be.

In summary, the way to being as successful as Warren Buffett in the stock market is through value investing. To accomplish this you must know when companies/securities are cheap. The key characteristics one must determine for a valuable cheap security are the Book Value per share vs price per share, P/E Ratio, financial position of the company, and future earnings. When a stock/bond can satisfy all these requirements it can turn out to be a great investment.

Pairing this with technical analysis from YP Investors will allow you to really increase your gains.
We hope this write-up on value investing can help you find stocks that will continue to grow your wealth so you can live the life you want!

• This topic was modified 1 year, 4 months ago by YP Investors.

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