How to Invest in Stocks

Success in the stock market boils down to buying quality companies at low prices.  Patience and discipline are the key ingredients, not complex charts or computer models.  Leave those to the professionals, the hedge funds and day-traders.  They are not your competition.  Your chances for success will be greater with a long-term outlook.  Buy with no intention of selling for a while.  You’ll avoid the trap of trying to time the market and instead harness the power of compound interest.  As time goes by, your money will grow faster and you’ll accumulate more.  If you keep it simple, your future self will thank you dearly.

THE INVESTOR’S CHECKLIST

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Is it an excellent company?

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Does it have growth potential?

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Is it selling at a low price?

“ALL THE MATH YOU NEED IN THE STOCK MARKET YOU GET IN THE FOURTH GRADE.”

–  Peter Lynch

Where to begin? It all starts with the business.  Without a basic understanding of the company behind the stock, you’ll have no idea if it’s priced low or high.  Prices often fluctuate for reasons that have nothing to do with a company’s performance, or because expectations for the company change.  Analysts are constantly revising their projections.  With so much noise surrounding the stock market, you must focus on hard data. This will tell us the true nature of the business, and we reduce our risk if we only buy shares of quality businesses.  Here are key ways to measure the health of a company:

OPERATIONS

  • RETURN ON INVESTED CAPITAL - profit earned on the cash invested in the company, i.e. your money.  Look for one above 10%.
  • OPERATING MARGIN - profitability as a percentage of its revenue, after operating costs.
  • DEBT TO EQUITY - a high ratio means the company funds its growth through borrowing cash, which is not a sustainable method for success.
  • CASH TO DEBT - signifies the ease with which a company could pay off its debt.

“IN THE BUSINESS WORLD, THE REARVIEW IS ALWAYS CLEARER THAN THE WINDSHIELD.”

–  Warren Buffet

Company growth is critical to increasing shareholder value.  A rise in share price without any underlying growth in the business makes for a shaky foundation.  And be wary of speculation regarding future performance; predictions are a constant feature in the world of Wall Street, but they’re often wrong.  Consider a company’s recent past when trying to assess whether it has growth potential in the years ahead.  It’s the most tangible evidence we have that they’re set up for the future.  Here are some key metrics to examine:

GROWTH

  • EARNINGS PER SHARE - net profit allocated to each share.  Increasing earnings is a fundamental goal of any business.
  • SALES PER SHARE - aka revenue. Some companies may not yet turn a profit, so sales growth is an important indicator that they’re moving in the right direction.
  • BOOK VALUE PER SHARE - what's left for shareholders if all debts are paid. A rising book value helps enable company expansion.
  • FREE CASH FLOW PER SHARE - ‘cash is king’. It cannot be manipulated and allows for financial flexibility and freedom.

“ALL INTELLIGENT INVESTING IS VALUE INVESTING – ACQUIRING MORE THAN WHAT YOU ARE PAYING FOR.”

–  Charlie Munger

Share price at face value means nothing.  A stock selling at $100 per share may be cheaper than one selling at $10.  It all depends on how it’s priced relative to the company’s performance, and a few simple measurements can guide us.  For example, it will help to look at the share price relative to the company’s earnings – the ‘P/E ratio’.  Generally, the lower the ratio, the better the value, since you’re effectively getting more bang for your buck. Here are the four commonly used price ratios:

VALUE

  • PRICE TO EARNINGS (P/E) - the price for each dollar in company earnings.
  • PRICE TO SALES (P/S) - particularly useful for early-stage companies that don’t yet turn a profit.
  • PRICE TO BOOK VALUE (P/B) - most significant for companies heavy in physical assets.
  • PRICE TO CASH FLOW (P/C) - susceptible to fewer factors than earnings.

Note that companies may have low price ratios because nobody wants to buy them.  They’re on the clearance rack for a reason.  Perhaps they’re in an industry that’s being phased out.  Maybe they’re getting wiped up by the competition, or they’re just poorly managed.  That’s why it’s important that you begin with the business itself.  The clues will be there. If the data isn’t strong, move on. 

As the legendary investor Phil Fisher advised, “it is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens.”  If you buy something that’s undervalued, it may stay that way for a while, but it’s not up to you to determine for how long.  Remember, the market is very reactionary. Billions of shares are traded every day.  Deciding when the market will get behind, or give up on, a stock is none of your business.  Your business is finding the business.