Stock-picking: There are hundred of different ways to skin a cat.

No investor can possibly hope to keep up with the more than 13,000 companies whose stocks are traded on the major exchanges in the US markets today.  That's why amateurs and pros alike are forced to cut down on their options by specializing in one kind of company or another. 

• For instance, some investors buy stocks only in companies that have a habit of raising their dividends. 
• Others look for companies whose earnings are growing by at least 20% a year.
• You can specialise in a certain industry, such as electric utilities, or restaurants or banks. 
• You can specialize in small companies or large companies, new companies or old ones. 
• You can specialise in companies that have fallen on hard times and are trying to make a comeback.  (These are called "turnarounds.")

Looking at the investment world by studying the numbers. (2)

Studying the numbers

That a company makes a popular product doesn't mean you should automatically buy the stock.  There's a lot more you have to know before you invest. 

• You have to know if the company is spending its cash wisely or frittering it away. 
• You have to know how much it owes to the bank. 
• You have to know if the sales are growing, and how fast. 
• You have to know how much money it earned in past years, and how much it can expect to earn in the future. 
• You have to know if the stock is selling at a fair price, a bargain price, or too high a price.

You have to know if the company is paying a dividend, and if so,

• how much of a dividend, and
• how often it is raised.  

Earnings, sales, debt, dividends, the price of the stock:  These are some of the key numbers stockpickers must follow.

People go to graduate school to learn how to read and interpret these numbers, so this is not a subject that can be covered easily in depth for others.  The best is to give a glimpse at the basic elements of a company's finances, so you can begin to see how the numbers fit together.

Investing is not an exact science, and no matter how hard you study the numbers and how much you learn about a company's past performance, you can never be sure about its future performance.  What will happen tomorrow is always a guess. 

• Your job as an investor is to make educated guesses and not blind ones. 
• Your job is to pick stocks and not pay too much for them, then to keep watching for good news or bad news coming out of the companies you won. 
• You can use your knowledge to keep the risks to a minimum.

Looking at the investment world through a stockpicker's eyes (1)

Keep your eyes opened

You can begin to gather information every time you walk into a McDonald's, a Sunglass Hut International, or any other store that's owned by a publicly traded company.  And if you work in the store, so much the better.

You can see for yourself whether the operation is efficient or sloppy, overstaffed or understaffed, well-organized or chaotic.  You can gauge the morale of your fellow employees.  You get a sense of whether management is reckless or careful with money.

If you're out front with the customers, you can size up the crowd. 

• Are they lining up at the cash register, or does the place look empty? 
• Are they happy with the merchandise, or do they complain a lot? 

These little details can tell you a great deal about the quality of the parent company itself. 

• Have you ever seen a messy Gap or an empty McDonald's? 

The employees at any of the Gap outlets or the McDonald's franchises could have noticed long ago how fantastically successful these operations have been and invested their spare cash accordingly.

A store doesn't have to fall apart to lose customers.  It will lose customers when another store comes along that offers better merchandise and better service, for the same prices or lower prices.  Employees are among the first to know when a competitor is luring the clients away.  There's nothing to stop them from investing in the competitors. 

Even if you don't have a job in a publicly traded company, you can see what's going on from the customer angle. 

• Every time you shop in a store, eat a hamburger, or buy new sunglasses, you're getting valuable input. 
• By browsing around, you can see what's selling and what isn't. 
• By watching your friends, you know which computers they're buying, which brand of soda they're drinking, which movies they're watching, whether Reeboks are in or out. 

These are all important clues that can lead you to the right stocks.

You'd be surprised how many adults fail to follow up on such clues.  Millions of people work in industries where they come in daily contact with potential investments and never take advantage of their front-row seat. 

• Doctors know which drug companies make the best drugs, but they don't always buy the drug stocks. 
• Bankiers know which banks are the strongest and have the lowest expenses and make the smartest loans, but they don't necessarily buy the bank stocks. 
• Store manangers and the people who run malls have access to the monthly sales figures, so they know for sure which retailers are selling the most merchandise.  But how many mall managers have enriched themselves by investing in specialty retail stocks.

Once you start looking at the world through a stockpicker's eyes, where everything is a potential investment, you begin to notice the companies that do business with the companies that got your attention in the first place.

• If you work in a hospital, you come into contact with companies that make sutures, surgical gowns, sysringes, beds and bed pans, X-ray equipment, EKG machines; companies that help the hospital keep its costs down; companies that write the health insurance; companies that handle the billing. 
• The grocery store is another hotbed of companies; dozens of them are represented in each aisle.

You also begin to notice when a competitor is doing a better job than the company that hired you. 

• When people were lining up to buy Chrysler minivans, it wasn't just the Chrysler salesmen who realized Chrysler was on its way to making record profits. 
• It was also the Buick salesmen down the block, who sat around their empty showroom and realized that a lot of Buick customers must have switched to Chrysler.

Doing your own research - the highest form of stock-picking

This is the highest form of stock-picking. 

You choose the stock because you like the company, and you like the company because you've studied it inside and out.

The more you learn about investing in companies, the less you have to rely on other people's opinions, and the better you can evaluate other people's tips.  You can decide for yourself what stocks to buy and when to buy them.

You'll need 2 kinds of information:

1. the kind you get by keeping your eyes peeled, and,
2. the kind you get by studying the numbers.

The first kind, you can begin to gather every time you walk into a McDonald's, a Sunglass Hut International, or any other store that's owned by a publicly traded company.  And if you work in the store, so much the better.

You can see for yourself whether the operation is efficeint or sloppy, overstaffed or understaffed, well-organized, or chaotic.  You can gauge the morale of your fellow employees.  You get a sense of whether management is reckless or careful with money.

Finding good quality successful companies

Stocks that do well in the long run belong to companies that do well in the long run.  The key to successful investing is finding successful companies. 

To get the most out of your investing, you have to do more than follow the prices of the stocks.  You have to learn as much as possible about the companies you've chosen and what makes them tick.

Here are the 5 basic methods people use to pick a stock (beginning with the most ridiculous and ending with the most enlightened).

1.  Darts (chosen randomly)
2.  Hot tips (from Uncle Harry)
3.  Educated tips (TV, newspapers, magazines)
4.  The broker's buy list
5.  Doing your own research.

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Warren Buffett's Priceless Investment Advice
By John Reeves
December 9, 2009

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

If you can grasp this simple advice from Warren Buffett, you should do well as an investor. Sure, there are other investment strategies out there, but Buffett's approach is both easy to follow and demonstrably successful over more than 50 years. Why try anything else?

Two words for the efficient market hypothesis: Warren Buffett
An interesting academic study illustrates Buffett's amazing investment genius. From 1980 to 2003, the stock portfolio of Berkshire Hathaway (NYSE: BRK-A) beat the S&P 500 index in 20 out of 24 years. During that period, Berkshire's average annual return from its stock portfolio outperformed the index by 12 percentage points. The efficient market theory predicts that this is impossible. In this case, the theory is clearly wrong.

Buffett has delivered these outstanding returns by buying undervalued shares in great companies such as Gillette, now owned by Procter & Gamble. Over the years, Berkshire has owned household names such as Walt Disney (NYSE: DIS), Office Depot (NYSE: ODP), and SunTrust Banks (NYSE: STI).

Although not every pick worked out, for the most part Buffett and Berkshire have made a mint. Indeed, Buffett's investment in Gillette increased threefold during the 1990s. Who'd have guessed you could get such stratospheric returns from razors?

The devil is in the details
Buying great companies at reasonable prices can deliver solid returns for long-term investors. The challenge, of course, is identifying great companies -- and determining what constitutes a reasonable price.

Buffett recommends that investors look for companies that deliver outstanding returns on capital and produce substantial cash profits.

• He also suggests that you look for companies with a huge economic moat to protect them from competitors.
• You can identify companies with moats by looking for strong brands that stand alongside consistent or improving profit margins and returns on capital.

How do you determine the right buy price for shares in such companies? Buffett advises that you wait patiently for opportunities to purchase stocks at a significant discount to their intrinsic values -- as calculated by taking the present value of all future cash flows. Ultimately, he believes that "value will in time always be reflected in market price." When the market finally recognizes the true worth of your undervalued shares, you begin to earn solid returns.

Do-it-yourself outperformance
Before they can capture Buffett-like returns, beginning investors will need to develop their skills in identifying profitable companies and determining intrinsic values. In the meantime, consider looking for stock ideas among Berkshire's own holdings.

The financial media made a big fuss over Berkshire's $44 billion acquisition of Burlington Northern Santa Fe, which has caused some of his recent stock selections to fly under the radar. For instance, Buffett just opened a position in ExxonMobil (NYSE: XOM), which joins ConocoPhillips (NYSE: COP) to comprise Berkshire's oil and gas exposure.

It's easy to see why Berkshire likes this efficient operator. ExxonMobil boasts a rock solid balance sheet and broad geographic diversification. Furthermore, Exxon should only benefit if commodity prices increase -- a theme consistent with Buffett's recent railroad purchase. And if Buffett's buying history is any guide, you can be confident that Exxon shares are trading at a discount to their intrinsic value.

So what will Buffett buy next? Unfortunately, we'll have to wait until Berkshire files its next Form 13-F to know for sure.

Of course, that's the problem with following Buffett's stock picks -- we'll never know what he's buying today until long after the fact. In the meantime, another place to find great value-stock ideas is Motley Fool Inside Value. Philip Durell, the advisor for the service, follows an investment strategy very similar to Buffett's.

He looks for undervalued companies that also have strong financials and competitive positions. Philip is outperforming the market with this approach, used since Inside Value's inception in 2004. In fact, Philip's recommendation for December is a pick that Buffett would love -- an electric utility with stable free cash flow, strong competitive advantages, and a 4.3% dividend yield. To read more about this stock pick, as well as the entire archive of past selections, sign up for a free 30-day trial today.

If investing in wonderful companies at fair prices is good enough for Warren Buffett -- arguably the finest investor on the planet -- it should be good enough for the rest of us.

Already subscribe to Inside Value? Log in at the top of this page.

This article was originally published on April 7, 2007. It has been updated.

John Reeves can't remember the last time he used a razor made by someone other than Gillette, and he wishes he'd owned shares in that company before P&G acquired it. John owns shares of Berkshire Hathaway. Berkshire Hathaway and Walt Disney are Motley Fool Inside Value and Stock Advisor recommendations. P&G is an Income Investor pick. The Motley Fool owns shares of Berkshire Hathaway and Procter & Gamble. The Fool has a disclosure policy.

http://www.fool.com/investing/value/2009/12/09/warren-buffetts-priceless-investment-advice.aspx

Picking next year's winners might be a lot tougher.

What Will Be the Best Stock for 2010?
By Dan Caplinger
December 15, 2009

During 2009, finding winning stocks was like shooting fish in a barrel. But if what goes up must come down, picking next year's winners might be a lot tougher.

Among more than 4,000 stocks with market caps above $100 million that traded on major U.S. stock exchanges, more than 700 have doubled in price this year, and 84 have managed to see their prices rise 400% or more. Some of the top gainers include:

Stock
2009 YTD Return

Diedrich Coffee (Nasdaq: DDRX)
9,578%

Human Genome Sciences (Nasdaq: HGSI)
1,247%

Pier 1 (NYSE: PIR)
1,235%

Kirkland's (Nasdaq: KIRK)
615%

Teck Resources (NYSE: TCK)
551%

Dendreon (Nasdaq: DNDN)
469%

Sirius XM Radio (Nasdaq: SIRI)
411%


Source: Capital IQ, a division of Standard and Poor's. As of Dec. 14.


No encore
With those staggering numbers almost in the record books, a repeat performance of 2009 seems unlikely for most of those stocks. Still, that doesn't mean that there won't be any great stock returns in 2010.

Nevertheless, I'm not going to try to sell you on any hot predictions for next year. After all, I'm still reeling from my pick of Diedrich as the year's scariest stock. The company went on to jump another 60% in the month or so after I made that call.

How about you?


http://www.fool.com/investing/general/2009/12/15/what-will-be-the-best-stock-for-2010.aspx

Doing Your Homework: Analysing Financial Statements to pick Great Stocks

How do you pick great stocks?

If you don't have a crystal ball or inside information, then the best way you can tell a winning stock from a loser is by analysing a company's financial statements.

Before you dismiss this simple answer because you find financial statements confusing or boring, you should know that you don't have to become an accountant or financial analyst.  Just a nodding acquaintance with the fundamentals will allow you to make better decisions about

• which stocks you should investigate and
• which stocks you should own as part of your (e.g. dividend-focused or growth-focused) portfolio.

Financial statements are an important source of information regarding a company's profits or losses, assets and liabilities, and sources of funds used to operate its business.  You should concentrate on the basics: 

• the balance sheet,
• income statement, and
• statement of retained earnings.

The balance sheet
This gives you an overall picture of a company's assets, liabilities, and equity at the end of an accounting period (i.e. quarterly or year-end).

The Income statement and the statement of retained earnings
These tell you how much revenue, expense, and profit the firm generated over a specific period of time (e.g. its fiscal year).

Together, these statements provide you with all the financial data you need to perform a ratio analysis to determine if you would want to buy a stock.

Since financial transactions occur continuously, this information becomes rapidly dated.  Be sure you are looking at the most recent statements and continue to review the updated statements of those stocks you decide to hold.

Future expectations can be approached in two different ways: Qualitative or Quantitative approach

According to Benjamin Graham, the current price reflects both

• known facts and
• future expectations

was intended to emphasize the double basis for market valuations.

Corresponding with these two kinds of value elements are two basically different approaches to stock analysis. 

Every competent analyst looks forward to the future rather than backward to the past, and realizes that their work will prove good or bad depending on what will happen and not on what has happened.

The future expectation itself can be approached in two different ways, which may be called:

• 1.  the way of prediction (or projection) and
• 2.  the way of protection.

-----

1. The way of prediction (or projection)

Those who emphasize prediction will try to anticipate fairly accurately just what the company will accomplish in future years - in particular whether earnings will grow rapidly and consistently.  These conclusions may be based on a very careful study of such factors as

• supply and demand in the industry-
• or volume, price and costs -
• or else they may be derived from a rather naive extrapolation from past growth into the future. 

If these authorities are convinced that the fairly long-term prospects are unusually favourable, they will almost always recommend the stock for purchase without paying too much attention to its current price.

This first, or predictive approach, could also be called the qualitative approach, since it emphasizes prospects, management and other nonmeasurable, abeit highly important factors that go under the heading of quality.

--

2. The way of protection.

By contrast, those analyst who emphasize protection are always especially concerned with the price of the stocks at the time of study.  Their main effort is to assure themselves of a substantial margin of present value above the market price - a margin large enough to absorb any unfavourable developments in the future.  Generally speaking, therefore, it is not so necessary for them to be enthusiastic over the company's long-run prospects as it is to be reasonably confident that the enterprise will get along.

The second or protective approach may be called the quantitative or statistical approach, since it emphasizes the measurable relationships between selling price and earnings, assets, dividends and so forth. 

Incidentally, the quantitative method is really an extention into the field of common stocks of the viewpoint that security analysis has found to be sound in the selection of bonds and preferred stocks for investment.

----

Choosing the "best" stocks is a controversial one.

In Benjamin Graham's own attitude and professional work was always committed to the quantitative approach. 

• From the first he wanted to make sure that he was getting ample value for his money in concrete, demonstrable terms. 
• He was not willing to accept the prospects and promises of the future as compensation for a lack of sufficient value in hand.

This has by no means been the standard viewpoint among investment authorities; in fact, the majority would probably subscribe to the view that prospects, the quality of management, other tangibles, and the "human factor" far outweigh the past performance records, the balance sheet and all other cold figures.

Thus this matter of choosing the "best" stocks is a controversial one.

The concept and purpose of using Screen and Standards in Stocks Selection

As you begin the process of culling your universe of stocks down to a useful list, think about the qualities you find in your candidates in terms of screens and standards.

 

Screen

 

A screen is any element of a security that would eliminate it from further consideration, for example, the absence of a dividend.

 

The purpose of a screen is to limit your universe of stocks to a manageable list of candidates. 

The concept of using a screen to narrow our choices is a familiar part of daily life.  For example:

• people with food allergies can't eat certain dishes, no matter how delicious they are.
• we only read books written in languages we understand, and
• when we shop for clothing we start by looking for clothes that will fit.  After all, it doesn't matter how nice an item is if it's not the right size.

Screens help us discard all the possibilities that, no matter what else they may have to offer, just don't meet our needs.  Any stocks that fails to meet one of your screens simply won't be on your list of candidates.

 

 

Standards

 

Standards are those criteria by which you will compare one security to another when both of them pass your screening process in order to select your perferred choice. 

 

The purpose of standards is to help you decide which stocks on your list of candidates to invest in. 

 

Returning to our shopping example, once we narrow our choices to those items that are the right size we can try them on to see which ones fit the best.  There are other clothing standards in addition to fit such as color, style, quality, and price that we can use to compare our finalists when deciding which ones to buy.

 

The stocks that pass through your screens will be ranked according to a variety of investment standards to help you find those candidates on your list that appear to offer the most promising fit for your dividend portfolio.


Sometimes a measurement you use as a screen to shorten your list will also be used as a standard to rank your choices. 

The most obvious screen you'll be running your universe through is the size of the dividend yield.  If you've set your minimum dividend yield at 2.25%, then a stock with a yield of 3% and another stock with a yield of 4% would both pass the dividend screen you've set and be added to your list of candidates. 

Later, when ranking your candidates to decide which ones to buy, you can use the dividend yield measurement again - but this time as a standard.  On the basis of the dividend yield standard, the 4% stock would rank higher than the one with a yield of 3%.

How high the dividend yield should be to pass through your screen depends largely on

• how much income you need to take from your portfolio, and
• how much risk you're comfortable assuming. 

If you haven't stopped to address these two important factors, now would be a great time to do so.

Stocks Pickers Vs Index Funds: The Debate Rages On

Stocks Pickers Vs Index Funds: The Debate Rages On

Published: Wednesday, 28 Oct 2009 | 11:19 AM ET Text Size
By: Chris Taylor,
Special to CNBC.com

In the investing world, the rivalry is akin to the Capulets and the Montagues. In one corner, active stockpickers and their belief in talented fund managers who can outperform the market; in the other, passive investors who prefer less-risky portfolios of low-cost broad market indices.

It’s a question that will be debated forever on trading-room floors and investor chat rooms, but what investors want to know: Who has the best approach for right now, after a quick post-collapse runup that has the Dow Jones Industrial Average breaking the magical 10,000 level?

The answer might be different than you expect. Conventional wisdom holds that active management performs best in a declining market, when stockpickers can sidestep the dogs like a Lehman Brothers or an AIG [AIG 35.75 -0.64 (-1.76%) ]. But here’s a secret: It’s a total myth.

“Everyone believes that active investors do well in bad markets,” says Srikant Dash, global head of research and design for S&P Index Services. “But when we looked at the bad markets of 2002 and 2008, we showed conclusively that it’s not true.”

What Dash found in his SPIVA scorecard that compares active and passive investing: Then—and over any five-year time horizon you’d care to mention—about two-thirds of fund managers underperform the stock market. In other words, over the long term, plain-vanilla index funds clobber many of the best minds in the business.

Complete Stock Market Coverage
For right now, though, there’s some evidence that active investors could be coming into their moment. After all, the Dow was up an eye-popping 15 percent last quarter, as investors regained their confidence and money rushed back in from the sidelines. That’s the Dow’s best performance since 1998, rebounding smartly from a low of around 6,500.

If one assumes that such a rapid ascent won’t be replicated in the near-term, and that we can expect a relatively flat, range-bound market in coming months, then broad indices won’t be going anywhere. Active managers, on the other hand, could thrive with their more judicious stockpicking.



Just ask George Athanassakos. The chair of the Ben Graham Centre for Value Investing in London, Ontario, Athanassakos ran a study comparing a stockpicking approach to the performance of market indexes. He discovered that in straight bull markets, when a rising tide lifted all boats, his value-oriented stock selections were almost exactly aligned with the broader market.


But in flat or zig-zag markets, his active style destroyed the indices, beating them by almost 50 percent. If that’s the kind of market we’re entering, then active investors should take heart.

“When the market goes up, then everyone is doing well,” says Athanassakos, a finance professor and author of the book "Equity Valuation." “It’s hard to buy low and sell high when there’s a straight line up. So active management becomes especially important when the market moves within a band.”

Moreover, it’s usually in the aftermath of a big market move, like the one we’ve just experienced, that you discover a few glaring market inefficiencies.

“When prices have all moved in one direction, there’s more opportunity for mispricing to emerge,” says Josh Peters, an equities analyst with Chicago-based research firm Morningstar.

And a continued bull run looks unlikely, Peters suggests, since underlying fundamentals like corporate revenues and abysmal employment figures mean the economy’s not out of the woods yet.

If that’s the case—that the general market takes a breather, and some relative values begin to stick out—then where should stockpickers place their bets? Active investors would do well to focus on yields, Peters advises.

After all, if stock prices remain range-bound, then it’s dividend payouts that will largely be determining your returns. High-yielding, blue-chip firms tend to be resilient, without a huge downside, because investors are attracted to the stability and income they provide.

Sector Watch Performance
They’ve also been lagging the broader market recently, as the hottest stars have been previously left-for-dead firms like MGM. That discrepancy makes for some juicy values. Some of Peters’ picks: Johnson & Johnson [JNJ 62.19 0.76 (+1.24%) ], Abbott Labs [ABT 53.63 0.68 (+1.28%) ], and Altria [MO 19.34 0.08 (+0.42%) ], all overlooked giants that continue to throw off cash.

“They’re not trading at unreasonable valuations, those stocks don’t need a quick V-shaped recovery,' he says. "And you don’t need a whole lot to go right for those investments to work.”

© 2009 CNBC.com

http://www.cnbc.com/id/33289460

Stock-Picking Strategies: Value Investing

Stock-Picking Strategies: Value Investing

Value investing is one of the best known stock-picking methods. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: find companies trading below their inherent worth.

The value investor looks for stocks with strong fundamentals - including earnings, dividends, book value, and cash flow - that are selling at a bargain price, given their quality. The value investor seeks companies that seem to be incorrectly valued (undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.

Can value companies be those that have just reached new lows? - Definitely, although we must re-emphasize that the "cheapness" of a company is relative to intrinsic value.

A company that has just hit a new 12-month low or is at half of a 12-month high may warrant further investigation.

Here is a breakdown of some of the numbers value investors use as rough guides for picking stocks. Keep in mind that these are guidelines, not hard-and-fast rules:

• Share price should be no more than two-thirds of intrinsic worth.
  
• Look at companies with P/E ratios at the lowest 10% of all equity securities.
  
• PEG should be less than one.
  
• Stock price should be no more than tangible book value.
  
• There should be no more debt than equity (i.e. D/E ratio < 1).
  
• Current assets should be two times current liabilities.
  
• Dividend yield should be at least two-thirds of the long-term AAA bond yield.
  
• Earnings growth should be at least 7% per annum compounded over the last 10 years.

The Margin of Safety

A discussion of value investing would not be complete without mentioning the use of a margin of safety, a technique which is simple yet very effective. Consider a real-life example of a margin of safety. Say you're planning a pyrotechnics show, which will include flames and explosions. You have concluded with a high degree of certainty that it's perfectly safe to stand 100 feet from the center of the explosions. But to be absolutely sure no one gets hurt, you implement a margin of safety by setting up barriers 125 feet from the explosions.

This use of a margin of safety works similarly in value investing. It's simply the practice of leaving room for error in your calculations of intrinsic value. A value investor may be fairly confident that a company has an intrinsic value of $30 per share. But in case his or her calculations are a little too optimistic, he or she creates a margin of safety/error by using the $26 per share in their scenario analysis. The investor may find that at $15 the company is still an attractive investment, or he or she may find that at $24, the company is not attractive enough. If the stock's intrinsic value is lower than the investor estimated, the margin of safety would help prevent this investor from paying too much for the stock.

Conclusion

Value investing is not as sexy as some other styles of investing; it relies on a strict screening process. But just remember, there's nothing boring about outperforming the S&P by 13% over a 40-year span!

http://www.investopedia.com/university/stockpicking/stockpicking3.asp

Stock-Picking Strategies: Fundamental Analysis

Stock-Picking Strategies: Fundamental Analysis

Ever hear someone say that a company has "strong fundamentals"? The phrase is so overused that it's become somewhat of a cliché. Any analyst can refer to a company's fundamentals without actually saying anything meaningful. So here we define exactly what fundamentals are, how and why they are analyzed, and why fundamental analysis is often a great starting point to picking good companies.

The Theory

Doing basic fundamental valuation is quite straightforward; all it takes is a little time and energy. The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a fancy term for what you believe a stock is really worth - as opposed to the value at which it is being traded in the marketplace. If the intrinsic value is more than the current share price, your analysis is showing that the stock is worth more than its price and that it makes sense to buy the stock.


Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: a company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. And these future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today. (For further reading, see Understanding the Time Value of Money).


The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses - the basis of intrinsic value.



Greater Fool Theory

One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute. The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies. This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies. (We'll talk more about technical analysis and how it works in a later section.)



Putting Theory into Practice

The idea of discounting cash flows seems okay in theory, but implementing it in real life is difficult. One of the most obvious challenges is determining how far into the future we should forecast cash flows. It's hard enough to predict next year's profits, so how can we predict the course of the next 10 years? What if a company goes out of business? What if a company survives for hundreds of years? All of these uncertainties and possibilities explain why there are many different models devised for discounting cash flows, but none completely escapes the complications posed by the uncertainty of the future.


Let's look at a sample of a model used to value a company. Because this is a generalized example, don't worry if some details aren't clear. The purpose is to demonstrate the bridging between theory and application. Take a look at how valuation based on fundamentals would look:




The problem with projecting far into the future is that we have to account for the different rates at which a company will grow as it enters different phases. To get around this problem, this model has two parts:

(1) determining the sum of the discounted future cash flows from each of the next five years (years one to five), and

(2) determining 'residual value', which is the sum of the future cash flows from the years starting six years from now.

In this particular example, the company is assumed to grow at 15% a year for the first five years and then 5% every year after that (year six and beyond). First, we add together all the first five yearly cash flows - each of which are discounted to year zero, the present - in order to determine the present value (PV). So once the present value of the company for the first five years is calculated, we must, in the second stage of the model, determine the value of the cash flows coming from the sixth year and all the following years, when the company's growth rate is assumed to be 5%. The cash flows from all these years are discounted back to year five and added together, then discounted to year zero, and finally combined with the PV of the cash flows from years one to five (which we calculated in the first part of the model). And voilà! We have an estimate (given our assumptions) of the intrinsic value of the company. An estimate that is higher than the current market capitalization indicates that it may be a good buy. Below, we have gone through each component of the model with specific notes:

1. Prior-year cash flow - The theoretical amount, or total profits, that the shareholders could take from the company the previous year.
2. Growth rate - The rate at which owner's earnings are expected to grow for the next five years.
3. Cash flow - The theoretical amount that shareholders would get if all the company's earnings, or profits, were distributed to them.
4. Discount factor - The number that brings the future cash flows back to year zero. In other words, the factor used to determine the cash flows' present value (PV).
5. Discount per year - The cash flow multiplied by the discount factor.
6. Cash flow in year five - The amount the company could distribute to shareholders in year five.
7. Growth rate - The growth rate from year six into perpetuity.
8. Cash flow in year six - The amount available in year six to distribute to shareholders.
9. Capitalization Rate - The discount rate (the denominator) in the formula for a constantly growing perpetuity.
10. Value at the end of year five - The value of the company in five years.
11. Discount factor at the end of year five - The discount factor that converts the value of the firm in year five into the present value.
12. PV of residual value - The present value of the firm in year five.

So far, we've been very general on what a cash flow comprises, and unfortunately, there is no easy way to measure it. The only natural cash flow from a public company to its shareholders is a dividend, and the dividend discount model (DDM) values a company based on its future dividends (see Digging Into The DDM.). However, a company doesn't pay out all of its profits in dividends, and many profitable companies don't pay dividends at all.


What happens in these situations? Other valuation options include analyzing net income, free cash flow, EBITDA and a series of other financial measures. There are advantages and disadvantages to using any of these metrics to get a glimpse into a company's intrinsic value. The point is that what represents cash flow depends on the situation. Regardless of what model is used, the theory behind all of them is the same.

Reference:


http://www.investopedia.com/university/stockpicking/stockpicking1.asp?partner=WBW
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