Value Based Stock Investing

Disciples of stock guru Benjamin Green engage in value based stock investing. Value based stock investing works on the principle that the stock market always finds the true value of a stock, even though that process may take a little time. Popular stocks may be overpriced and lightly followed stocks may be underpriced. However, when the market in general does the necessary technical and fundamental analysis of a given stock it prices the stock appropriately. An easy tool to use for value based stock investing is the price to earnings ratio. Mr. Green and subsequent value investors consider two things in appraising a stock. One is the current price and the other is a fair estimate of future stock earnings. The working assumption in value based stock investing is that an overpriced stock can be quickly recognized by its high price to earnings ratio or, better, by a high price to earnings ratio using anticipated earnings. Likewise a stock with high anticipated earnings may be underpriced as the price to earnings ratio is based upon current reported earnings and not upon the prediction of future earnings. Value investors believe that all stocks will eventually return to their fair market price. As such they sell overpriced stocks and buy underpriced stocks in anticipation of profits.

In value based stock investing investors consider the book value of a company and its earnings, preferably an accurate assessment of anticipated earnings. The formula includes a “fudge factor” of 22.5 and calculates the square root of earnings per share multiplied by book value per share. An average Graham number is 1.5. The Graham number is read like the price to earnings ratio. High is overpriced and low is underpriced. Whereas value based stock investing considers a price to earnings ratio of more than fifteen to be high, a Graham number of one and a half carries the same implication. In picking new winners in the stock market, value investors focus on these numbers. When a market downturn occurs it is often a field day for value based stock investing as stocks with substantial long term value are available for low Graham numbers or price to earnings ratios. Value based stock investing seeks to find profit in individual stocks. In addition to stocks with attractive PE ratios or Graham numbers investors look at just what a company does, how well they do it, and how much profit they make, or could make, in the future.

A good example of an attractive stock for value based stock investing might be DDI Corp – DDIC – who design and make circuit boards. Its Graham number implies that it should be priced fifty percent higher. It is mid cap stock which means that fewer analysts follow it than follow large cap stocks causing its promising financials to be overlooked by the market in general. By comparison Quaker Chemical Corp – KWR – is a specialty chemical maker that lost nearly ten percent in the last year but whose Graham number implies a real value of nearly thirty percent more that its current price. This is where knowing what the company does and how it fits into the overall picture is essential for value stock investing. A company whose business will falter during an economic downturn may have a low price to earnings ratio or Graham number but, in fact, may be liable to a lower set of numbers if the current recession worsens. A large cap company may or may not be a good stock investment based on value based stock investing principles. Companies like ExxonMobil – XOM, Freeport-McMoRan Copper & Gold Inc. – FCX, Delta Airlines – DAL, or Hewlett Packard – HPQ may or may not be fairly priced depending upon the state of the economy but they are typically followed closely by many stock analysts so that their market price is typically closer to what value investing considers a fair market value.

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