Using Internet Sources for Research
Introduction
It's amazing how much attention some people pay to garbage news, stock quotes, blogs, and how little they pay to the value of the underlying businesses they are buying.
You should evaluate stocks as pieces of a business and not as "little wiggling things with charts attached." Purchasing shares of superior businesses at discounts to their fair values, and allowing those businesses to compound value over (positive) periods of time, is the surest way to create wealth in the stock market.
When stocks are high and richly valued, relatively few will receive the highest of consensus ratings. But when the market tumbles, there will be many more available with improving - consensus ratings.
What Is Fair Value?
Most any investment, whether it's buying a home or purchasing a stock, boils down to an initial outlay followed by (hopefully) a stream of future income. The trick is deciding on a fair price to pay for that expected stream of future income.
Let's say a stock trades at 20 per share. If you crunch the numbers -- projected sales growth, future profit margins, and so on -- you might estimate the stock's fair price per share to be 30. You pay 20 for the stock, and in return you receive a stream of income valued at 30. That's a great deal. If the stock was trading at 40, above the 30 fair value of the future income stream, you are looking at an expensive stock.
How Do Arrive at a Top Rating?
That's simple, stocks ratings are based on a stock's market price relative to its estimated fair value, adjusted for risk. Generally speaking, stocks trading at large discounts to fair value estimates will receive higher ratings, and stocks trading at large premiums to their fair value estimates will receive lower ratings. Stocks that are trading very close to fair value estimates will usually get an average rating.
Not all companies are created equal. The future is inherently uncertain, and that uncertainty is greater for some companies than others. So one should require larger discounts to fair value for riskier or uncertain businesses.
When investing in any asset, you should expect a return that adequately compensates you for the risks inherent in the investment. The cost of equity is often called the "required return," because it represents the return an investor requires for taking on the risk of owning a stock.
Guidance: Actually, your job is to reduce the "risk of owning a stock" to near zero! When that is not possible, simple hold cash. The old risk / reward ratio is an important formula for you to develop, within your own personal risk tolerance, and apply each and every time you invest your money.
What Causes a Star Rating to Change?
The ratings can change because of a move in the stock's price, a change in the analyst's estimate of the stock's fair value, a change in the analyst's assessment of a company's business risk, or a combination of any of these factors.
It is important to note that our fair value estimates do not change very often, but the market prices do. Therefore, stocks or mutual funds often gain or lose stars based just on movement in the share price. If we think a stock's fair value is $50, and the shares decline to $40 without a change in the intrinsic value of the business, the star rating will go up. Our estimate of what the business is worth hasn't changed, but the shares are more attractive as an investment at $40 than they were at $50.
A Different Valuation Approach
If you've ever talked about P/E or P/B, you have valued stocks using ratios, also known as multiples. Investors like to use ratios because they are easy to calculate and readily available. The downside is that making sense of valuation ratios usually requires a bit of context. A company can have a high P/E or P/B but still be cheap based on fair value. If a computer company can grow fast enough, its stock will deserve a high P/E, and it might even be a bargain. Likewise, a company in a dying industry with negative growth may have a low P/E and still be overvalued.
Looking at future profits allows for a more sophisticated approach to stock valuation. By determining a company's fair value based on a projection of a company's future cash flows, we can determine whether a stock is undervalued or overvalued. The advantage of this approach is that the result is easy to understand and does not require as much context as the basic ratios. While it takes more time and expertise to estimate future cash flows, analyst believe that valuing stocks in this way allows investors to spot bargains and make more intelligent investments.
The Bottom Line
Above all, keep in mind that true investing means buying a stake in a superior business at a discounted price and allowing that business to compound in value over a period of time. It isn't hopping on the latest hot concept hoping for a quick profit. The value of owning stock is tied to how much value the company generates for its shareholders.
It's amazing how much attention some people pay to garbage news, stock quotes, blogs, and how little they pay to the value of the underlying businesses they are buying.
You should evaluate stocks as pieces of a business and not as "little wiggling things with charts attached." Purchasing shares of superior businesses at discounts to their fair values, and allowing those businesses to compound value over (positive) periods of time, is the surest way to create wealth in the stock market.
When stocks are high and richly valued, relatively few will receive the highest of consensus ratings. But when the market tumbles, there will be many more available with improving - consensus ratings.
What Is Fair Value?
Most any investment, whether it's buying a home or purchasing a stock, boils down to an initial outlay followed by (hopefully) a stream of future income. The trick is deciding on a fair price to pay for that expected stream of future income.
Let's say a stock trades at 20 per share. If you crunch the numbers -- projected sales growth, future profit margins, and so on -- you might estimate the stock's fair price per share to be 30. You pay 20 for the stock, and in return you receive a stream of income valued at 30. That's a great deal. If the stock was trading at 40, above the 30 fair value of the future income stream, you are looking at an expensive stock.
How Do Arrive at a Top Rating?
That's simple, stocks ratings are based on a stock's market price relative to its estimated fair value, adjusted for risk. Generally speaking, stocks trading at large discounts to fair value estimates will receive higher ratings, and stocks trading at large premiums to their fair value estimates will receive lower ratings. Stocks that are trading very close to fair value estimates will usually get an average rating.
Not all companies are created equal. The future is inherently uncertain, and that uncertainty is greater for some companies than others. So one should require larger discounts to fair value for riskier or uncertain businesses.
When investing in any asset, you should expect a return that adequately compensates you for the risks inherent in the investment. The cost of equity is often called the "required return," because it represents the return an investor requires for taking on the risk of owning a stock.
Guidance: Actually, your job is to reduce the "risk of owning a stock" to near zero! When that is not possible, simple hold cash. The old risk / reward ratio is an important formula for you to develop, within your own personal risk tolerance, and apply each and every time you invest your money.
What Causes a Star Rating to Change?
The ratings can change because of a move in the stock's price, a change in the analyst's estimate of the stock's fair value, a change in the analyst's assessment of a company's business risk, or a combination of any of these factors.
It is important to note that our fair value estimates do not change very often, but the market prices do. Therefore, stocks or mutual funds often gain or lose stars based just on movement in the share price. If we think a stock's fair value is $50, and the shares decline to $40 without a change in the intrinsic value of the business, the star rating will go up. Our estimate of what the business is worth hasn't changed, but the shares are more attractive as an investment at $40 than they were at $50.
A Different Valuation Approach
If you've ever talked about P/E or P/B, you have valued stocks using ratios, also known as multiples. Investors like to use ratios because they are easy to calculate and readily available. The downside is that making sense of valuation ratios usually requires a bit of context. A company can have a high P/E or P/B but still be cheap based on fair value. If a computer company can grow fast enough, its stock will deserve a high P/E, and it might even be a bargain. Likewise, a company in a dying industry with negative growth may have a low P/E and still be overvalued.
Looking at future profits allows for a more sophisticated approach to stock valuation. By determining a company's fair value based on a projection of a company's future cash flows, we can determine whether a stock is undervalued or overvalued. The advantage of this approach is that the result is easy to understand and does not require as much context as the basic ratios. While it takes more time and expertise to estimate future cash flows, analyst believe that valuing stocks in this way allows investors to spot bargains and make more intelligent investments.
The Bottom Line
Above all, keep in mind that true investing means buying a stake in a superior business at a discounted price and allowing that business to compound in value over a period of time. It isn't hopping on the latest hot concept hoping for a quick profit. The value of owning stock is tied to how much value the company generates for its shareholders.