In order to choose which stocks to buy you need to know the price and the value, in order to buy stocks that are trading at a discount.
The price is known, meanwhile intrinsic value (the value of the entire company) can be estimated; and after adding a margin of safety, and dividing the value of the company by the number of shares, we can guess if the stock is worth buying at the current price.
You can also own the stocks for the dividends they pay, but you might not want to base your choice only on the amount of dividends, because you don’t want to own shares whose price is dropping more that they are earning you in dividends.
To calculate the intrinsic value of a stock, you need to know how much money the company is generating (its cash flow), which can be found in the company’s cash flow statement, you need to estimate the growth rate of that cash flow over the period in which you are planning to own the stock, i.e. the rate of increase of the cash flow. This growth rate can be estimated from the previous numbers in the cash flow statement.
Then, you need to discount all the future cash flows because money generated in the future is less valuable then money generated now. This can depend on the value of inflation, and how much other investments might be paying during the same period; because it is riskier to buy single stocks than a mutual fund or a market index, we should be getting a higher return (or at lease aiming for a higher return) when buying single stocks. You need to add all those future cash flows for the period that you plan to hold the stock for, and finally you need to estimate a sale factor, i.e. how much would you sell the company for after that period.
Then you add a safety margin, and you buy below that value. You can increase the margin of safety to be more aggressive and more secure about your choice, which might make it more difficult at times to come by stocks with that amount of discount.
We need to keep in consideration that intrinsic value is not an exact number, it is just an estimation, therefore it is absolutely necessary to not use it blindly, without understanding the business of the company, looking at the company’s balance sheet, and maybe leaving out the smaller, less established companies, which have a higher growth rate, but are more risky.
Assuming that we guessed the right value, the stock value is supposed to go toward that value sometime in the future, but we don’t know when. It could be days, month, years, or maybe never.
But always remember that this is just an estimation, we just need it because it is better to aim at something rather than nothing, and that sometimes this can be misleading. If for instance, the cash flow is negative because the company is expanding. And bear in mind when estimating a growth rate that a company’s growth rate tends to slow down overtime as the company becomes bigger, and you can’t assume that a company will continue to grow with the same rate for an extended period of time.
In the end keep in mind that I am not qualified to give financial advice, I do NOT have a degree in finance or economics, and thus use this information at your own risk, I am NOT responsible for ANY action you take, nor shall I be held liable for any of your decisions.
Happy investing!
This was not written by Thndr and this is not investment advice, you should do your own research before making investment decisions.
