The most difficult part of becoming a value investor is doing the research to thoroughly analyze a company. That’s probably the reason why everyone is not a value investor.
Value investing takes work. You can’t just tune in to CNBC or Bloomberg TV and have your stock pick of the week. What you have to do is to determine that a company is fundamentally sound, that its financial statements are healthy, and that it has a competitive advantage over its rivals. All of that research requires that you read annual reports for the company you are researching as well as its competitors in order to evaluate risk and the company’s future prospects. Once all that is complete and you’ve determined that the company is indeed a good one to invest in, you have to determine whether the current share price is trading at a discount. If the share price is not trading at a discount, then it makes no sense to buy the stock at a premium. That would defeat the purpose of investing in the company since its future growth is already priced into the stock price. The 3 steps to become a successful Value Investor are:
Step 1: Screen Out Stocks
The first thing to do is narrow the list of stocks to evaluate by screening out companies that are generally not good value investing stocks. This would include eliminating companies with no earnings, high debt-to-equity ratios, micro-cap stocks, companies whose return-on-equity is below 10%, and companies without consistent positive free cash flow.
Fortunately there are free tools available that help with the screening process and many brokerage firms also provide self-service screeners to account holders that help narrow down the search for stocks based on criteria you select.
Step 2: Read the Annual Reports
After 90% of the companies have been screened out, you can then start taking a deeper dive into the company’s fundamentals, researching its competitors, and assessing its prospects for growth. This is really the time to do your due diligence. Read the company’s annual reports, including the 10k report, analyze its financial statements, and assess its management and strategy for growth. If you only want to read one document, make sure it’s the 10k report and you read and understand it cover to cover. If the business model is too complex and you are not crystal clear on how the company makes its money, move on to another company.
Step 3: Determine Intrinsic Stock Value
Perhaps the most challenging of calculations is the valuation of a stock based on the future cash flow of the company. Determining the intrinsic value of stocks is tricky because you have to make a couple of assumptions about the future, which is never a sure thing, and there are tedious calculations that must be computed. Changing your assumptions requires that you recalculate the stock value.
Using tools like the Intrinsic Stock Value Calculator you could do Step 3 before Step 2 to get a quick decision on whether to proceed with doing further research on a company, but the values you enter into the calculator should be based on sound judgment and a review of the company’s financial statements. The growth rates should be determined by reading the annual reports and management’s plans for the company.
If you find that the intrinsic value you computed is higher than the current share price after you’ve completed all 3 steps, then you may have found a great investment and are well on your way to become a successful value investor.