In the depths of the Great Depression Benjamin Green introduced investors to the concept of value based stock investing. According to Mr. Green investors could use value based stock investing for long term profits if they based their investment choices on stock fundamentals. Value based investing works on two principles. There is always a degree of market inefficiency due to lack of information, poor information, or market psychology. And the market eventually discovers the true value of any given stock as fundamental analysis comes to the fore. Investors who study the fundamentals to discover the intrinsic value of a stock and its margin of safety will tend to profit in the long term. But, what the tools that one must use in value investing for long term profits?
How Does the Stock Compare to Others?
A quick and useful comparison for value investing for long term profits is to look at the price to earnings ratio (P/E ratio) of a given stock. The P/E ratio is a good measure of how the market views the stock. Compare the P/E ratio of stock in which you are interested to the P/E ratio of other stocks in its market sector. When a company is growing rapidly, investors will often pay more for the stock than if it is not. Thus a fast growing stock will often have a high P/E ratio. This is a warning for long term investors as much of the anticipated price increase of that stock has already been priced into the stock by the market. In value investing for long term profits it is often wise to look for stocks with low price to earnings ratios. Always compare stock earnings to stock price before you invest.
What Sort of Profits Does the Future Hold?
In using value investing for long term profits, investors look for the intrinsic value of a stock. What is intrinsic stock value? The intrinsic value of a stock is its future income stream discounted to present day value. For example, you expect the stock to be worth twice as much in ten years. You expect its dividend to double. And you expect interest rates to rise and make the US dollar less valuable. Then compare the value of today’s stock to AAA bonds or US Treasuries at today’s interest rates. What can you expect to earn from a solid interest bearing investment? Run that investment back to today and compare it with your stock price and anticipated earnings to see the intrinsic value of your stock. A stock that is undervalued in this context is commonly a good long term investment.
Margin of Safety
Finding the margin of safety of a stock is a useful means of assuring against loss. Value investing for long term profits requires a little safety as well as a little promise. Companies that have unencumbered assets such as bank deposits, property, patents, and the like are more likely to survive a recession intact than companies with excessive debt. Look for what keeps a company in the game when times are tough and that factor what you need to find in value investing for long term profits.