Identifying a Value Stock
Value investors search for stocks that have been overlooked by the market and as a result their price is below their actual value. The ignorance of the market is not linked in any way to the economic fundamentals of the company that has issued the stock. Additionally, they look for stocks that are sold at a discount to their intrinsic value.
However, this investment philosophy has its drawbacks. Namely, most investors find it difficult to determine the intrinsic value of the company.
Thus, establishing a margin of safety is recommended. This allows you for some room in case you make any mistakes when calculating the intrinsic value of the stock.
The margin of safety will provide with more certainty when deciding whether the current price is the right one at which you should purchase the stock. Thus, stern discipline about the establishing the right stock price is needed. If the price you have established as the right one is not equal to the current price of the stock, it may be better to pass the stock and look for another one.
Some important financial numbers you should look at when examining a value stock include:
- Price to Cash Flow ratio
- Price to Book ratio
- Price to Earnings ratio
- Price to Sales ratio
When examining these ratios you should establish a benchmark against which to measure them. The most often used is the S&P 500. The ratios should be below the S&P 500 numbers that are typical of the industry in which the company issuing the stock operates.
Remember that you should look for companies that have been overlooked by the market, not because of a problem in their business fundamentals, but for some other reason. Don't bet on companies that are in front of bankruptcy.
Therefore, it is important to study the business fundamentals of the company. You should pay special attention to its debt ratio.
Additionally, you should study the cash flow that the company generates. If the debt of the company is reasonable and it provides a good cash flow, then the company is a good candidate for making an investment in it.
A company doesn't have to produce some outstanding product. In our daily lives we make use of many products that we don't notice at all, but someone has produced them.
A low stock price doesn't indicate problems with the company. Sometimes, low prices are illogical as compared with the potential of the company.
High growth prospects are not a must have for value stocks. If the target stock does not provide relatively high growth prospects as compared to other investment opportunities you should not exclude it as a potential value candidate.
All of these make a company a good candidate for a value stock.
To summarize, look for stocks that the market has overlooked and as a result are sold under their intrinsic value. Always include a margin of safety when purchasing a stock in order to insure yourself against a potential mistake in the determination of the intrinsic value of the company.
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