How to Find Value

Criteria for Being an Investor Possessing Intelligence

8. Company is not followed by equity research analysts or is hated by them

If everyone else already knows about how great a stock is, chances are that it will not meet the following criteria that I am going to outline. An intelligent investor has the confidence to give up following the herd in the market. Value investing involves long holding periods and belief in one's critical thinking abilities.

7. Price near a 52 week low.

Although cheap stocks can exist at any price, being near a 52 week low often means that the investment will be getting value from technical analysis indicators. A stock can be undervalued and become even cheaper before it goes back up to its true value. It is important to always get in at the best price within reason or not buy the security. The stock's price should be the determining factor in making an investment decision. The lower the price becomes, the less risky the security becomes. A simple indicator for judging an oversold stock is the Relative Strength Index with a 15 period parameter. Values under 30 suggest the stock may be oversold.

6. Current ratio greater than 2

Companies must remain liquid to stay in business. Therefore, companies with this amount of coverage for their short-term liabilities will be better able to survive times of reduced credit.

5. Only buy non-financial companies

Financial companies engage in operations that make it difficult to correctly value their assets and liabilities. Because banks hold so many structured and illiquid financial assets, even the individuals in charge of valuing them do not always know what they are worth. That is why the boom in inexpensive credit default swaps occurred that helped fueled the latest financial crisis. The model that priced these securities was inherently flawed. Unless an investor holds an advanced degree in financial modeling, I do not think they could possibly begin to understand what a bank is actually worth. The following article illustrates the complexity of pricing credit default swaps and what can happen when it goes wrong.

http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=1

An intelligent investor must have an intimate understanding of the operations of the company. Simple operations can often be best for investing. If an investor does not completely understand the company's operations and its products, then he is just a speculator.

4. Long-term debt to equity less than 1

Funding operations with more equity than debt leaves shareholders with less risk. Having a target of .5 for an all-equity portfolio is ideal. Discretion can be made on a company by company basis in order to include certain companies with a debt-to-equity ratio closer to one. These companies may be in industries where having a higher percentage of debt is common practice.

3. Positive retained earnings

Having positive retained earnings tells an immediate story about a company's history. Positive retained earnings means that the company has made money in the past and kept onto it.

2. Distributes a dividend

A stock can only have fundamental value to a minority share owner if the company distributes a dividend. Receiving a dividend from the company is extremely important because companies usually do not reinvest every dollar in projects with better than average returns. Companies eventually run out of the best projects to invest in within a given industry. Therefore, instead of leaving that cash with the company to squander on bad ideas, investors should demand the cash in the form of a dividend payment. Project returns for companies can display the same leptokurtic returns that stocks display. A company can make a lot of correct investment choices, but it only takes one large mistake or change in the market to cause the company to go bankrupt.

If an investor owned a horse shoe producer company that never gave a dividend, he would have probably lost his entire investment when automobiles came along. Because the future is always uncertain, it is advantageous for an investor to receive a share of the company's earnings along the way.

1. Price-to-book value of equity less than 1

This is the most important measurement of value. The largest margin of safety exists when an investor buys a company in the market for less than its intrinsic worth. The investor can afford the company to lose money in the future and not be greatly affected.

The following is an illustration of an intelligent investment given its p/b:

XYZ Company had an IPO five years ago. In 2008, XYZ had $10 of book value and earned $2 in net income per year going back 5 years. In the most recent year, XYZ lost $3 in net income that carried over to its book value. This created a lot of anxiety in analysts covering XYZ. They all downgraded XYZ to sell on worries that earnings will not reach $2 again. The $3 loss for XYZ was attributed to cyclical and structural changes in the economy. Analysts estimates for XYZ's next year earnings are $.40 and $.75 the year after that. The structural changes in the market place might cause XYZ to never make more than $1 again. In 2008, XYZ was trading at $19.00, but now it is trading at $5.00. No one on the street wants to put XYZ back in their portfolio. Ben, an intelligent investor, however, knows that XYZ is intrinsically worth $7. Paying $5 for an asset already worth $7 with positive future earnings is a value investment. XYZ is trading near a 30% discount to book value. Once XYZ goes back to earning money for the next couple of years, investors and analysts will realize that the company is trading much cheaper than other investment opportunities, and the market price of XYZ should return back to its book value or higher.