Tag Archives: Investing

Value Investing: The 4 Ms of Investing

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“The one and only secret to stockpiling is to make sure the value of the business is substantially greater than the price you are paying for it. If you get this right, you cannot help but get rich.” ~ Phil Town

Value investing is a strategy that focuses on investing in individual assets, but not just any asset, assets in wonderful companies or real estate that are priced well below their value, explains Phil Town, founder and CEO of Rule 1 Investing.

Value investing aims to reduce risk by increasing understanding of what you’re investing in order to make wiser investment decisions, and purchasing it at a price that gives you a margin of safety.

  • Value investing is a focused, disciplined and patient strategy, it’s a buy-and-hold for the long-term strategy. You need to be disciplined, patient and keep your focus on long-term profits.
  • It’s about making investing decisions based on the intrinsic value of a company, or what it’s actually worth, which is not to be confused with its sticker or market price.
  • A key component of value investing is buying stocks at the right time, and the right time will present itself if you remain focused, disciplined and patient.
  • The value investor isn’t swayed by the general public’s reaction or market fear. Fear can make people sell too early or miss an excellent opportunity to buy. But, the value investor decides when to buy or sell based on a wonderful company’s intrinsic value, not based on the prevailing fear or greed in the stock market.

Growth at a Reasonable Price (GARP)

Value investors focuses on finding companies that were both undervalued and are what you might call “wonderful companies” with a high potential for growth. Thus, it wasn’t enough for a company to just be undervalued. Instead, the best companies to invest in were ones that were both undervalued and wonderful companies.

To spot undervalued companies, it’s also important to ensure that the companies you are investing in are high-quality and can retain their value throughout the time that you are holding them. Phil Town likes to evaluate whether or not a business is a quality company with what he calls the 4 Ms of Investing: Meaning, Management, Moat, and Margin of Safety.

If you can check off each of these 4 Ms for a company you are considering investing in, it will be well worth your while.

Meaning

The company should have meaning to you. This is important because if it has meaning to you, you understand what it does and how it works and makes money, and will be more likely to do the research necessary to understand all elements of the business that affect its value.

Management

The company needs to have solid management. Perform a background check on the leaders in charge of guiding the company, paying close attention to the integrity and success of their prior decisions to determine if they are good, solid leaders that will take the company in the right direction.

Moat

The company should have a moat. A moat is something that separates them from the competition and, thus, protects them. If a company has patented technology, control over the market, an impenetrable brand, or a product or service customers would never switch from, it has a moat.

Margin of Safety

In order to guarantee good returns, you must buy a company at a price that gives you a margin of safety. For Rule #1 investors, 50% is the margin of safety to look for, explains Town. This provides a buffer that makes it possible to still experience gains even if problems arise. This is arguably the most important.

These 4Ms draw heavily from the rules of value investing. Both sets of rules dictate that you must buy a company below its actual value in order to make a profit. That’s the bottom line.

Even if a company is in a great position today, it needs to have future potential to triple or 10x your investment. The market cap is a reflection of what you would pay today to own a piece of the company. But the market price is not the true value of the company.

You, as a value investor, should rely on the “intrinsic value” to determine whether a company is a worthy value investment. Then, you can use the market cap to help you determine if the company is on sale and if it has the growth potential.

References:

  1. https://wp.ruleoneinvesting.com/blog/how-to-invest/value-investing/
  2. https://www.ruleoneinvesting.com/blog/financial-control/market-capitalization/

Phil Town is an investment advisor, hedge fund manager, and 3x NY Times Best-Selling Author. Phil’s goal is to help you learn how to invest and achieve financial independence.

Recession and Investing

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A recession is a period of economic contraction. Recessions are typically accompanied by falling stock markets, a rise in unemployment, a drop in income and consumer spending, and increased business failures. ~ SoFi

Liz Young, Head of Investment Strategy at SoFi, talks recession.

A recession describes a contraction in economic activity, often defined as a period of two consecutive quarters of decline in the nation’s real Gross Domestic Product (GDP) — the inflation-adjusted value of all goods and services produced in the United States. However, the National Bureau of Economic Research, which officially declares recessions, takes a broader view — including indicators like wholesale-retail sales, industrial production, employment, and real income.

Recessions tend to have a wide-ranging economic impact, affecting businesses, jobs, everyday individuals, and investment returns. But what are recessions exactly, and what long-term repercussions do they tend to have on personal financial situations? Here’s a deeper dive into these economic contractions.

It’s worth remembering some investments do better than others during recessions. Recessions are generally bad news for highly leveraged, cyclical, and speculative companies. These companies may not have the resources to withstand a rocky market.

By contrast, the companies that have traditionally survived and even outperformed during a downturn are companies with very little debt and strong cash flow. If those companies are in traditionally recession-resistant sectors, like essential consumer goods, utilities, defense contractors, and discount retailers, they may deserve closer consideration.

During a recession, it’s important to remember two key tenets that will help you stick to your investing strategy.

  1. The first is: While markets change, your financial goals don’t.
  2. The second is: Paper losses aren’t real until you cash out.

The first tenet refers to the fact that investors go into the market because they want to achieve certain financial goals. Those goals are often years or decades in the future. But as noted above, the typically shorter-term nature of a recession may not ultimately impact those longer-term financial plans. So, most investors want to avoid changing their financial goals and strategies on the fly just because the economy and financial markets are declining.

The second tenet is a caveat for the many investors who watch their investments — even their long-term ones — far too closely. While markets can decline and account balances can fall, those losses aren’t real until an investor sells their investments. If you wait, it’s possible you’ll see some of those paper losses regain their value.

So, investors should generally avoid panicking and making rash decisions to sell their investments in the face of down markets. Panicked and emotional selling may lead you into the trap of “buying high and selling low,” the opposite of what most investors are trying to do.

Stay the course and stick to your financial plan to survive a recession!

Source: https://www.sofi.com/learn/content/investing-during-a-recession/

6 Common Causes of Recessions

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“A soft landing is impossible. The economy is going to go into a recession fast. You’re going to see the economy just screech to a halt. That’s what the Fed needs to do to get inflation down.” ~ Mike Novogratz, Galaxy Digital CEO

The causes of recessions can vary greatly, according to the FinTech company Sofi. Generally speaking, recessions happen when something causes a loss of confidence among businesses and consumers. The recession that occurred in 2020 could be considered an outlier, as it was mainly sparked by an external global health event rather than internal economic causes.

The mechanics behind a typical recession work like this: consumers lose confidence and stop spending, driving down demand for goods and services. As a result, the economy shifts from growth to contraction. This can, in turn, lead to job losses, a slowdown in borrowing, and a continued decline in consumer spending.

According to SoFi, here are some common causes of recessions:

1. High Interest Rates

High interest rates make borrowing money more expensive, limiting the amount of money available to spend and invest. In the past, the Federal Reserve has raised interest rates to protect the value of the dollar or prevent the economy from overheating, which has, at times, resulted in a recession.

For example, the 1970s saw a period of stagnant growth and inflation that came to be known as “stagflation.” To fight it, the Fed raised interest rates throughout the decade, which created the recessions between 1980 and 1982.

2. Falling Housing Prices

If housing demand falls, so does the value of people’s homes. Homeowners may no longer be able to tap their house’s equity. As a result, homeowners may have less money in their pockets to spend, reducing consumption in the economy.

3. Stock Market Crash

A stock market crash occurs when a stock market index drops severely. If it falls by at least 20%, it enters what is known as a “bear market.” Stock market crashes can result in a recession since individual investors’ net worth declines, causing them to reduce spending because of a negative wealth effect. It can also cut into confidence among businesses, causing them to spend and hire less.

As stock prices drop, businesses may also face less access to capital and may produce less. They may have to lay off workers, whose ability to spend is curtailed. As this pattern continues, the economy may contract into recession.

4. Reduction in Real Wages

Real wages describe how much income an individual makes when adjusted for inflation. In other words, it represents how far consumer income can go in terms of the goods and services it can purchase.

When real wages shrink, a recession can begin. Consumers can lose confidence when they realize their income isn’t keeping up with inflation, leading to less spending and economic slowdown.

5. Bursting Bubbles

Asset bubbles are to blame for some of the most significant recessions in U.S. history, including the stock market bubble in the 1920s, the tech bubble in the 1990s, and the housing bubble in the 2000s.

An asset bubble occurs when the price of an asset, such as stock, bonds, commodities, and real estate, quickly rises without actual value in the asset to justify the rise.

As prices rise, new investors jump in, hoping to take advantage of the rapidly growing market. Yet, when the bubble bursts — for example, if demand runs out — the market can collapse, eventually leading to recession.

6. Deflation

Deflation is a widespread drop in prices, which an oversupply of goods and services can cause. This oversupply can result in consumers and businesses saving money rather than spending it. This is because consumers and businesses would rather wait to purchase goods and services that may be lower in price in the future. As demand falls and people spend less, a recession can follow due to the contraction in consumption and economic activity.

How Do Recessions Affect You?

Businesses may have fewer customers when the economy begins to slow down because consumers have less real income to spend. So they institute layoffs as a cost-cutting measure, which means unemployment rates rise.

As more people lose their jobs, they have less to spend on discretionary items, which means fewer sales and lower revenue for businesses. Individuals who can keep their jobs may choose to save their money rather than spend it, leading to less revenue for businesses.

Investors may see the value of their portfolios shrink if a recession triggers stock market volatility. Homeowners may also see a decline in their home’s equity if home values drop because of a recession.

When consumer spending declines, corporate earnings start to shrink. If a business doesn’t have enough resources to weather the storm, it may have to file for bankruptcy.

Governments and central banks will often do what they can to head off recession through monetary or fiscal stimulus to boost employment and spending. “It’s hard to not underestimate the huge impact that the response to COVID-19 had on all assets. We pumped so much liquidity into the markets it was crazy, we had never seen anything like it. We were throwing trillions of dollars around like matchsticks,” said Mike Novogratz, Galaxy Digital CEO.

Central banks, like the Federal Reserve, can provide monetary policy stimulus. The Fed can lower interest rates, which reduces the cost of borrowing. As more people borrow, there’s more money in circulation and more incentive to spend and invest.

Source: https://www.sofi.com/learn/content/what-is-a-recession/

Dividend Growth Stocks

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Dividend-growth stocks typically exhibit stable earnings, solid fundamentals and strong histories of profit and growth.

Dividend Growth companies are companies that have consistently grown their dividends over the long-term, such as for at least 15 consecutive years. According to ProShares, these companies generally come with attributes of quality that investors have come to expect:

  • Durable competitive advantages, solid fundamentals, and management teams that are committed to returning capital to shareholders.
  • Higher gross and net profit margins than the broader index, with more consistent levels of earnings growth through the market’s ups and downs.
  • Lower levels of debt than companies in the broader market index.

Dividend growers have also demonstrated a history of weathering market turbulence over time. They’ve done so by delivering most of the market’s upside in rising markets with considerably less of the downside in falling ones—a valuable feature in times of uncertainty.

“Dividend growth stocks have outperformed in various market environments,” according to global investment management firm Nuveen. “Dividend growth stocks have provided an attractive combination of earnings and cash flow growth potential, healthy balance sheets and sustainable dividend policies. These stocks have historically offered compelling performance during up markets and provided a buffer during market drawdowns and in volatile environments.”

When the Federal Reserve shifts from an accommodative monetary easing policy to a restrictive monetary policy, there is often an initial period of market volatility and uncertainty.

Dividend growth has been a desirable trait for equities immediately before, during, and after past cycles of less accommodative Fed policy.

Many investing gurus recommend strong dividend payers as the way to weather dual challenges of inflation and recession, noting that the dividend stocks’ income streams are capable of offsetting inflation – even when inflation is running higher than 8%.

“Dividend growth is one of the few things that has kept up with inflation as you go back and look over the decades. So when you go back and you look at the ’70s, ’80s — which is the last time you can actually find any notable inflation — what you see is dividend growth pretty much kept pace with it,” explained Sharon Hill, the co-leader of Vanguard’s Equity Income Fund.

With the three challenges facing investors today—rising interest rates, slowing economic growth and income scarcity–dividend growth stocks could make a better choice for the current economic and market environment.

Source: ProShares, Bloomberg. Data from 12/31/05 to 12/31/21. Past performance does not guarantee future results. Index calculations do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged, and one cannot invest in an index.

High-quality companies that have consistently grown their dividends tend to have stable earnings, solid fundamentals and strong histories of profit and growth. As a result, they have been generally better positioned to weather potentially slowing growth.

References:

  1. https://finance.yahoo.com/news/investing-whiz-sharon-hill-says-155244449.html
  2. https://www.fidelity.com/insights/investing-ideas/10-dividend-growth-stocks
  3. https://www.proshares.com/browse-all-insights/insights/three-reasons-dividend-growth-may-be-the-right-approach
  4. https://www.proshares.com/browse-all-insights/insights/why-dividend-growth-mid-caps-may-belong-in-your-portfolio

Best Investing and Trading Advice

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  1. “History repeats because of the weakness of human nature. The greed for quick fortunes has cost the public countless millions of dollars. Every experienced stock trader knows that overtrading is his greatest weakness, but he continues to allow this weakness to be his ruin. There must be a cure for this greatest weakness in trading, and that cure is STOP LOSS ORDERS. The weakest point must be overcome and the stop loss order is the cure for overtrading.” ~ WD Gann
  2. The only true test of whether a stock is “cheap” or “high” is not its current price in relation to some former price, no matter how accustomed we may have become to that former price, but whether the company’s fundamentals are significantly more or less favorable than the current financial-community appraisal of that stock.” ~ Philip Fisher
  3. “Trading is a waiting game. You sit, you wait, and you make a lot of money all at once. Profits come in bunches. The trick when going sideways between home runs is not to lose too much in between.” ~ Michael Covel
  4. “I learned to avoid trying to catch up or double up to recoup losses. I also learned that a certain amount of loss will affect your judgment, so you have to put some time between that loss and the next trade.” ~ Richard Dennis
  5. “Trading is a psychological game. Most people think they are playing against the market, but the market doesn´t care. You’re really playing against yourself.” ~ Martin Schwarz
  6. “Value investing requires a great deal of hard work, unusually strict discipline, and a long-term investment horizon. Few are willing and able to devote sufficient time and effort to become value investors, and only a fraction of those have the proper mind-set to succeed.” ~ Seth Klarman

References:

  1. https://www.t3live.com/blog/2017/12/01/best-trading-investing-quotes/

Investing Lessons Learned

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“To maximize returns, buy stocks when everyone hates them and sell them when everyone loves them. This is easy in theory, but brutally difficult in practice.” ~ Brian Feroldi

Brian Feroldi is a financial educator and he has been saving and investing for 18+ years. From his experiences, below he shares 10 painful lessons he had to learn and sometimes relearn the hard way:

1. You don’t need leverage.

Margin and options are fun on the way up and BRUTAL on the way down. Many investors have lost more than 100% on investment before. Why? Leverage.

Buffett said it best:

2. Optimize for longevity, not upside

Compound interest is the most powerful wealth-building force that exists. But, it only works if you SURVIVE long enough for it to work.

You must avoid investing to optimize for upside potential. Instead, you should follow the barbell method to optimize for longevity.

3. High conviction DOES NOT = correct

If you convinced yourself that a certain stock could only go up. you might be right on some. On others, you may lost significant value.

Conviction is useful, but just because you think you are right doesn’t mean that you are right.

Allocate accordingly

4. Stock prices and business results (and intrinsic value) are 0% correlated in the short-term and 100% correlated in the long-term

Do not sell future mega-winners because their stocks were down (dumb).

Instead of watching the stock, instead focus on the fundamentals of the business.

5. Not having a system

Do not try to keep everything in my head, which was dumb (and impossible).

Instead, use checklists, journals, or watchlist, which are invaluable free tools.

6. Not understanding the P/E ratio

Do not pass on high P/E ratio stocks that went up big and buy low P/E ratio stocks that went down big.

Why? It’s about understanding the P/E ratio’s flaws.

Now, P/E only works in stage 4. It doesn’t work in stages 1, 2, 3 or 5

7. Panic selling and panic buying

Emotions have caused many investors to panic buy hype stocks and panic sell future mega-winners.

It’s easy to say you’ll be greedy when others are fearful, and visa-versa.

It’s hard to actually do it.

8. Study history

Human nature is remarkably consistent. The same forces that drove markets 100+ years still exist in all of us today.

There’s always a smart-sounded reason to sell and it’s important to understand that.

9. Don’t focused on what you can’t control

Do not follow the news closely, or watch for clues to predict the market.

This will be time poorly spent. Macro factors matter, but you have no control over them.

It essential you focus far more on what you can control.

10. Not changing your mind

This one is REALLY hard, but it’s necessary to do well.

Changing your mind is hard. Admitting you’re wrong is hard.

But, @JeffBezos said it best:

Learning invaluable investing lessons, especially from the mistakes of others, is an essential part of becoming a more successful long-term investor.

References:

  1. https://bookshop.org/shop/Feroldi
  2. https://www.marketwatch.com/amp/story/the-critical-money-and-investing-lessons-i-wish-my-younger-self-had-understood-11651762064
  3. http://mindset.brianferoldi.com

How to Invest for Beginners: Peter Lynch

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Investing can be for anybody, but is certainly not for everybody.

Only a handful of professional investors can compare to the legendary Peter Lynch. He rose to investing stardom in 1977 when he was appointed the fund manager of Fidelity’s Magellan Fund.

When Lynch took over, the fund had around $18 million in assets under management. After 13 years at the helm, Lynch increased the fund’s size by almost a thousand-fold.

In 1990, the Magellan Fund, and its over $14 billion in assets under management, became the biggest mutual fund in the world. At times, the fund held over 1,000 different stocks in its portfolio. Also, there was a period when it had an average annual return of 29.9%.

It doesn’t matter if you don’t know anything about investing, since there are actions a beginning investor can take to learn how to invest and how to manage their money and finances. One of the most important actions for new investors is to get started early.

Investing doesn’t have to be hard. Yet, it’s important to learn the basics of investing and what type of investments are the best depending on your financial situation and the amount of money you want to make. 

When you make it a point to save money, you are protecting yourself against life’s unforeseen difficulties. And when you invest, if you choose to do so, you will have a chance to earn much more than you would have expected to, growing your money exponentially.

Time Period

Long-term investing is one of the key concepts in Lynch’s and many of the most successful investor’s investment philosophy. Lynch argued that the value of stocks was rather easy to predict over a 10 to 20-year period, while short term predictions were pretty much useless and effectively impossible to make accurately due to market volatility.

Source: Brian Feroldi

Therefore, he strongly urged investors to always select stocks of companies that they understand, believe in and be patient to wait for them to go up over a long period of time rather than selling for profits.

According to research, if you invest a $1,000 every year on the highest day for a period of 30 years, you can expect a 10.6% annualized return. On the other hand, if you invest the same sum on the lowest day of the year, you can expect an 11.7% compounded return over the same period.

Peter Lynch also encouraged the reader to look for the tenbagger stocks.

A tenbagger is a stock that rises in value 10-fold or 1,000%. He advises against selling when the stock goes up 40% or even 100%. Instead, he urges investors to hold onto them for the long-term, despite the common trend of many investors to take profits by selling appreciated stocks.

References:

  1. https://finmasters.com/one-up-on-wall-street-review/
  2. https://www.benzinga.com/money/peter-lynch-books

Burton G. Malkiel: Index Funds and Bond Substitutes

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Burton Gordon Malkiel, the Chemical Bank Chairman’s Professor of Economics, has been responsible for a revolution in the field of investing and money management. And he’s also author of the widely influential investment book, A Random Walk Down Wall Street.

His book, A Random Walk Down Wall Street, first published in 1973, used research on asset returns and the performance of asset managers to recommend that all investors would be wise to use passively managed total market “index” funds as the core of their investment portfolios. An index fund simply buys and holds the securities available in a particular investment market.

There were no publicly available index funds when Malkiel in a Random Walk first advanced this recommendation, and investment professionals loudly decried the idea. Today, indexing has been adopted around the world.

Additionally, Malkiel believes that investors “probably needs to take a bit more risk on that stable part of the portfolio”. One asset class that he recommends, instead of low yielding bonds, is preferred stocks. There are good-quality preferred stocks, which are basically fixed-income investments. They’re not as safe as bonds. Bonds have a prior claim on corporate earnings.

According to Malkiel, investors need some part of the portfolio to be in safe, bond like assets–such as preferred stocks, or what he calls bond substitutes, for at least some part of their portfolio.

He suggest a preferred stock of like JPMorgan Chase. He doesn’t think you’re taking an enormous amount of risk. The banks now have much more capital. They are constrained by the Federal Reserve in terms of what they can do and buying back stock and increasing their dividends. And with a portfolio of diversified, high-quality preferred stocks, one can earn a 5% yield.

And if one wants to take on even a bit more risk, there are high-quality common stocks that also yield 5% or more: a stock like IBM, which has a very well-covered dividend, yields over 5%; AT&T– you can think of basically blue chips and they might play a role.

Regarding diversification, investors do need some income-producing assets in their portfolio. But his recommendation is that you think in the diversification of not simply bonds, but maybe some bond substitutes. However, there is a trade-off; there is going to be a little more risk in the portfolio. And one needs to recognize that there is not a perfect solution.

But part of the solution for an investor, especially a retired investor, must be to revisit their spending rule. If one is worried about outliving one’s money, then the spending rate has to be less. In part, it means maybe a bit more belt-tightening.

There’s no easy answer to this. Malkiel wished there were an easy answer that there’s a riskless way to solve the problem. But there isn’t. In terms of wanting more safety, one ought to be saving more before retirement, and maybe the answer is to be spending less in retirement. Thus, on a relative-value basis, things like preferred stocks, and some of the blue chips that have good dividends, and dividends that have been rising over time, ought to play at least some role in the portfolio.

In this age of “financial repression”, where safe bonds yield next to nothing, an asset allocation of 40% bonds is too high, states Malkiel. Now, of course, there’s not just one figure that fits all. For some people it might be 60-40 would be OK. But, in general, the asset allocations that Malkiel recommended have a much larger equity allocation and a much smaller bond allocation. And if you look at the 12th edition of Random Walk book, you’ll find that he has generally reduced the fixed-income allocation and increased the equity allocation–different amounts for different age groups,

References:

  1. https://dof.princeton.edu/about/clerk-faculty/emeritus/burton-gordon-malkiel
  2. https://www.morningstar.com/articles/995453/burton-malkiel-i-am-not-a-big-fan-of-esg-investing

Peter Lynch’s five rules to investing

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“If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the car pool or on the commuter train—and succumbing to the social pressure, often buys.” Peter Lynch

Legendary American investor Peter Lynch shared five rules everyone can follow when investing in the stock market.

Within his 13-year tenure, Lynch drove the Fidelity Magellan Fund to a 2,800% gain – averaging a 29.2% annual return. It is the best 20-year return of any mutual fund in history. He is considered the greatest money manager of all time, and he beat the market for so long through buying the right stocks.

No one can promise you Lynch’s record, but you can learn a lot from him, and you don’t need a billion-dollar portfolio to follow his rules.

https://youtu.be/6oYc3RbLO3Q

Lynch’s five rules for any investor in the stock market are listed below.

1. Know what you own

The most important rule for Lynch is that investors should know and understand the company they own.

“I’m amazed at how many people that own stocks can’t tell you, in a minute or less, why they own that particular stock,” said Lynch.

Investors need to understand the company’s operations and what they offer well enough to explain it to a 10-year-old in two minutes or less. If you can’t, you will never make money.

Lynch believes that If the company is too complicated to understand and how it adds value, then don’t buy it. “I made 10 to 15 times my money in Dunkin Donuts because I could understand it,” he said.

2. Don’t invest purely on other’s opinions

People do research in all aspects of their lives, but for some reason, they fail to do the same when deciding on what stock to buy.

People research the best car to buy, look at reviews and compare specs when buying electronics, and get travel guides when travelling to new places – But they don’t do the same due diligence when buying a stock.

“So many investors get a tip on a stock travelling on the bus, and they’ll put half of their life savings in it before sunset, and they wonder why they lose money in the stock market,” Lynch said.

He added that investors should never just buy a stock because someone says it is a great buy. Do your research.

3. Focus on the company behind the stock

There is a method to the stock market, and the company behind the stock will determine where that stock goes.

“Stocks aren’t lottery tickets, there’s no luck involved. There’s a company behind every stock; if a company does well, the stock will do well – It’s not complicated,” Lynch said.

He advises that investors look at companies that have good growth prospects and is trading at a reasonable price using financial data such as:

• Balance Sheet – No story is complete without a balance sheet check. The balance sheet will tell you about the company’s financial structure, how much debt and cash it has, and how much equity its shareholders have. A company with a lot of cash is great, as it can buy more stock, make acquisitions or pay off its debt.

  • Year-by-year earnings growth
  • Price-to-earnings ratio (P/E) – relative to historical and industry averages.
  • Debt-equity ratio
  • Dividends and payout ratios
  • Price-to-free cash flow ratio
  • Return on invested capital

4. Don’t try to predict the market

Trying to time the market is a losing battle. One thing to keep in mind is that you aren’t going to invest at the bottom. Buy stocks because you want to own the business long-term, even if the share price decreases slightly after you buy.

Instead of trying to time the bottom and throwing all your money in at once, a better strategy is gradually building your stock positions over time.

This approach spreads out your investments and allows you to buy into the market at different times at varying prices that ideally balance each other out versus investing one lump sum all at once.

This way, if you’re wrong and the stock continues to fall, you’ll be able to take advantage of the new lower prices without missing out.

“Trying to time or predict the stock market is a total waste of time because no one can do it,” Lynch said.

Corollary: Buy with a Margin of Safety: No matter how careful an investor is in valuing a company, she can never eliminate the risk of being wrong. Margin of Safety is a tool for minimizing the odds of error in an investor’s favor. Margin of Safety means never overpaying for a stock, however attractive the investment opportunity may seem. It means purchasing a company at a market price 30% or more below its intrinsic value.

5. Market crashes are great opportunities

Knowing the stock market’s history is a must if you want to be successful.

What you learn from history is that the market goes down, and it goes down a lot. In 93 years, the market has had 50 declines; once every two years, the market declines by 10%. of those 50 declines, 15 have declined by 25% or more – otherwise known as a bear market – roughly every six years.

“All you need to know is that the market is going to go down sometimes, and it’s good when it happens,” Lynch said.

“For example, if you like a stock at $14 and it drops to $6 per share, that’s great. If you understand a company, look at its balance sheet, and it’s doing well, and you’re hoping to get to $22 a share with it, $14 to $22 is terrific, but $6 to $22 is exceptional,” he added.

Declines in the stock market will always happen, and you can take advantage of them if you understand the company and know what you own.

References:

  1. https://dailyinvestor.com/finance/1921/peter-lynchs-five-rules-to-investing/

Discounted Cash Flow Analysis

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Discounted cash flow model can be used for financial valuation of a project, company, stock, bond or any income producing asset.

Discounted cash flow is a financial valuation method that calculates the value of an investment based on the present value of its future income or cash flow. The method helps to evaluate the attractiveness of an investment opportunity based on its projected future cash flows.

Free Cash flow to the firm (FCFF) means the amount of surplus cash flow available to a business after a it pays its operational expenses like inventory, rent, salaries etc. and also invests in fixed assets like plant and machinery, property etc. Cash is an important element of business. It is required for business functioning; some investors provide more value to cash flow statements than other financial statements.

Free cash flow is important metric as it tells about the company’s ability to deploy capital in future projects. Without cash, it’s tough to develop new products, make acquisitions, pay dividends, buyback shares and reduce debt. Also, as cash is difficult to manipulate compared to other variables, FCFF is more reliable indicator of a company’s performance than net earnings.

DCF model can be used for valuation of a project, company, stock, bond or any income producing asset. The DCF method can be used for the companies which have positive Free cash flows and these FCFF can be reasonably forecasted. So, it cannot be used for new and small companies or industries which have greater exposure to seasonal or economic cycles.

To use the Discounted Cash Flow Model to Value Stock:

Step 1 : Calculate the Free Cash flow to the firm

Step 2 : Project the future FCFF – You need to project the future FCFF for the next couple of years. You can analyze the historical data to understand the past FCFF growth trend. However, relying on historical data only won’t give you the right result, so consider the present financials as well as future potential of the company while projecting the growth rate. When conducting a DCF analysis, investors and businesses must make estimations for future cash flows and the future value of the investment. For instance, a company considering a new business acquisition must estimate the future cash flows from expanding its processes and operations with the acquisition. The estimates the company makes can help determine if the investment is worth the cost of the acquisition.

Step 3 : Discount the FCFF — Calculate the present value of this cash flow by adjusting it with the discount rate. Discount rate is your expected return %. The discount rate is one of the most important elements of the DCF formula. Businesses need to identify an appropriate value for the discount rate if they are unable to rely on a weighted average cost of capital. Additionally, the discount rate can vary depending on a range of factors like an organization’s risk profile and the current conditions of capital markets. If you are unable to determine a discount rate or rely on a WACC value, an alternative model may be more beneficial and accurate.

Step 4 : Calculate the Terminal Value — It is the value of the business projected beyond the forecasting period. It is calculated by assuming the constant growth of a company beyond a certain period known as terminal rate.

When valuing a business, the annual forecasted cash flows typically used are 5 years into the future, at which point a terminal value is used.  The reason is that it becomes hard to make reliable estimates of how a business will perform that far out into the future. There are two common methods of calculating the terminal value:

  • Exit multiple (where the business is assumed to be sold)
  • Perpetual growth (where the business is assumed to grow at a reasonable, fixed growth rate forever)

Step 5 : Add discounted FCFF with Terminal value and adjust the total cash and debt.

Step 6 : Divide the Figure calculated in Step 5 by the outstanding number of shares to find out the DCF Value.

Step 7 : Adjust the Margin of Safety to find out the Fair value. Margin of Safety provides discount for uncertainties in the business.

When assessing a potential investment, it’s important to take into account the time value of money or the required rate of return that you expect to receive.

The DCF formula takes into account how much return you expect to earn, and the resulting value is how much you would be willing to pay for something to receive exactly that rate of return.

  • If you pay less than the DCF value, your rate of return will be higher than the discount rate.
  • If you pay more than the DCF value, your rate of return will be lower than the discount.

The DCF formula is used to determine the value of a business or a security.  It represents the value an investor would be willing to pay for an investment, given a required rate of return on their investment (the discount rate).

When using the DCF analysis, determine the discount rate and have estimates for future cash flows. Apply these values in the DCF formula to create a future outline that details expected returns. If the results appear at or above a company’s initial projections for future cash flows, then investing can be beneficial. However, if the discounted cash flow formula results in a value below a company’s projected future returns, it may consider alternative investments.

References:

  1. https://www.finology.in/Calculators/Invest/DCF-Calculator.aspx
  2. https://corporatefinanceinstitute.com/resources/knowledge/valuation/dcf-formula-guide/
  3. https://www.indeed.com/career-advice/career-development/discounted-cash-flow