Value investing - Warren Buffet Strategy

 

IntrinsicValueGraph

 

"Though markets are generally rational, they occasionally do crazy things. Seizing the opportunities then offered does not require great intelligence, a degree in economics or a familiarity with Wall Street jargon such as alpha and beta. What investors need instead is an ability to both disregard mob fears or enthusiasms and to focus on a few simple fundamentals." -Warren Buffet

We often make investing harder than it needs to be. Warren Buffett follows a simple approach based on common sense. Everyone can certainly follow his investing tips. That doesn’t mean they are always easy to follow (and some are harder than the others) but persistence and knowledge expansion really goes a long way.

We can study long term value investing by following the Warren Buffett strategy. He has proven to be a disciplined follower of value principles for building wealth. By using his strategies we will definitely improve and sharpen our investment management skills.

Per Warren Buffett’s Value Investment Theory the buy decision should be based on several factors and value investor should have a list of questions to go thru while considering any stocks. Questions are not too complicated and it’s a great way to get introduced to some important concepts. To get answers to these questions, all that is needed is access to the company’s balance sheets and financial statements. You can find this information on the company website, or there is a host of resources such as Google Finance or Yahoo Finance.

  1. Do you understand the product or service offered by the company? (Make sure company is in your “circle of competence” and do not buy company you don’t understand!)
  2. Do you think people still be using company’s product or service in 10-15 years from now?
  3. Does the company have a low cost durable (lasting) competitive advantage?
  4. Is the company recession proof?
  5. Has the company had consistent earnings growth? (Generally EPS growth have to be over 7%)
  6. Has the company had consistent dividend growth? (Generally dividend growth have to be at least 7%)
  7. Does the company have low payout ratio? (We are looking for payout ratio 75% or less)
  8. Does the company have low debt? (Debt should be 70% or less)
  9. Does the company have a good credit rating? (must have minimum S&P credit rating of “BBB+)
  10. Is the stock undervalued?
  11. Company’s P/E Ratio must be below 15. The lower the better!
  12. Company’s current market price should be 20-30% less than calculated intrinsic value – “margin of safety price”.

Calculating and understanding intrinsic value of the stock is one of the most important steps in value investing but it doesn’t take a genius to do it.

 “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”  -Warren Buffet

The key is it to calculate the intrinsic value of a business correctly. If you are going to spend some money buying something or making an investment, you wouldn’t want to pay more than it worth. We don’t want to overpay. The tricky question is how to determine the real value of things? Because one thing is the price and other is the value.

There are few different approaches to calculate intrinsic value. Each approach has its own advantages and disadvantages. Even Warren Buffett and Charlie Munger use different models to calculate intrinsic value. 

For example, one way to calculate the intrinsic value is to use calculator based on Warren Buffett’s “Ten Cap Price” otherwise known as “Owner Earnings” calculation. After all, what could be more important than earnings, right? Warren Buffett calls Owner Earnings is one of the “most relevant item for valuation purposes – both for investors in buying stocks and for managers buying entire businesses.”

To calculate intrinsic value based on “Owner Earnings” we need several values. All those values found on company’s Annual Report.

  1. Net Income
  2. Depreciation and Amortization
  3. Net Change Accounts Receivable
  4. Maintenance Capital Expenditure
  5. Income Tax

Multiply result by 10 and divide by number of shares (you will get intrinsic value per share).

The logical question you would ask, is it possible for a good company to have the market price drop 20-30% bellow intrinsic value? The answer is: YES, It is possible due to various reasons. Those reasons are temporary and could include: bad news about the company, company's industry is out of market favor, market is in correction or recession...

YES, Recession! All statistical data show that we are in the next Market Bubble similar to "DOT-COM Bubble" of 2001 and "Housing Bubble" of 2008. It's just a matter of time before this Market Bubble will pop, presenting an opportunity for Value Investors to buy their favorite stocks for less than intrinsic value! In order to buy your favorite stocks for less than intrinsic value you need to be prepared. You need to know what this intrinsic value is and how to calculate it. Do your homework now! Prepare yourself for new opportunities! Be patient and keep emotions out of investing! Invest only in companies you thoroughly research and understand. The stock market will experience swings but in good times and bad stay focused on your goals. Raw intelligence is arguably one of the least predictive factors of investment success. Buffett believes the most important quality for an investor is temperament.

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ.” – Warren Buffett

 

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