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If you are starting out on the path of equity investing, wondering how to make the decision to buy or sell a stock, you will certainly come across Warren Buffett early in your research. Warren Buffett is widely regarded as one of the best investors alive.
So, how does he do it?
What are the principles by which he chooses a company in which to invest? The answers lie in the concept of value investing, the equity style to which he adheres. The value investor, as distinguished from other investor types, such as momentum, growth, or technical investors, dogmatically pursues the concept of Intrinsic value for a stock.
When he or she finds a stock trading at a meaningful discount to intrinsic value, he buys it. What, then, is intrinsic value? While there is some degree of subjectivity to the concept, it involves fundamental analysis of a company’s earnings power. Earnings and cash flow are predicted for a number of years into the future. Those earnings are discounted back at an appropriate interest rate, usually the company’s average cost of capital, to determine a present value. This present value is the intrinsic value and can be directly compared to share price. Subjectivity comes in the determination of the future earnings, as well as the discount rate.
Now, projecting future earnings may seem a daunting task. Using conservative assumptions can help minimize the impact of errors. Sometimes, examining what an independent third party might pay for a company as whole (i.e., a takeover) can augment the fundamental process described above.
This is helpful if your chosen company is in an industry undergoing rapid consolidation. You can see if the price paid to acquire a company outright corresponds to what you would have calculated its intrinsic value to be. Warren Buffett not only invests in publicly traded stocks, but he often buys companies entirely, when he finds the discount to intrinsic value too compelling to ignore.
Very few people get anything like their potential horsepower translated into their actual horsepower of their output in life. Potential exceeds realization for many people. The best asset is your own self. You can become to an enormous degree the person that you want to be. (Warren Buffett)
So, in summary, value investing entails the fundamental analysis of a company’s earnings power versus its current share price. Value investing has made Warren Buffett and many of his colleagues famously rich.
Not a bad model to emulate.
(Source Warren Buffett, Berkshire Hathaway, CNBC)
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