Thursday, November 13, 2008

Value Investing

The copy of The Intelligent Investor that I have is the 4th Revised edition, Copyright 1973. In the appendix is an article by Warren Buffett called The Superinvestors of Graham-and-Doddsville. It's a great article and if you get a chance check it out. There is one simple and powerful message that really stood out to me and basically summarizes Value Investing. If you could pay $.40 for $1 would you do it?

Simple right but why is it so hard to apply in the stock buying universe? I think my biggest problem in the past trying to understand the concept was trying to value a stock based on the future expectations of a company. If sales and income are going up 100% or whatever #, then a stock selling at a high Price to Earnings ratio should make sense to buy. My experience buying these companies is generally the future expectations do not work out like planned so the high P/E ratio becomes excessively high and the stock price soon drops. So how do I pay 40 cents for a dollar bill?

The first criteria I came up with is low P/E ratio based on average earnings for the last 5 years and the current stock price. I defined low as P/E around 10. So to use some simple numbers, if a stock sells at $10, the average earnings for the last 5 years should be around $1. My thinking goes like this: I'm receiving $1 in earnings from this company for every $10 I'm investing. If the company is running its business well some of those earnings will come back to me in dividends and some will be reinvested to build the business so it can earn even more money for me in the future.

Here's what i'm trying to say using big fancy words. I want to buy stock in companies with higher intrinsic value than market capitalization value. One simple criteria to begin identifying these companies is by using the P/E ratio.

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