Warren Buffett says it in it simplest form: Risk is not knowing what you are doing.
Every form of investment involves guessing the future, but nobody is good in that and therefore there is always a certain degree of uncertainty (or risk) in investing.
Value investing minimizes that risks by evaluating a company, as if you have a share of the company (you do when you eventually bought shares of that company). In general, a company must be at least financially strong and consistently profitable. Next, the investor has to use his funds efficiently. I will share my thoughts on efficiency in the next post.
Financially Strong
Some of the measures to determine if the company is financially strong are:
Book Value Per Share: Book value is also the net asset value (or equity - see how confusing things can be?) after minusing the liabilities. The per-share value is commonly used by some investor as the proxy for intrinsic value of a company. For example, if a company's book value is $1 per share, and the share price is at $0.90, it is deemed a bargain, because you are paying a discount of $0.10 for some share of the assets which are valued (in the balance sheet) at $1 per share. However, this is assessment is generally not accurate, because there is more to the intrinsic value of a company. How wonder it would if it is so simple?
Furthermore, future money, such as Receivables and Payables can be so inflated that it can create a false reality of the financial strength of the company, especially the Receivables since they are considered as assets.
Current Ratio: The current ratio, current assets/current liabilities, measures how much current assets a company has in excess of the current liabilities. This ensures that the company can fulfill its short-term financial obligations.
Debt/Equity Ratio: Debt and Equity are capital sources of the company. This ratio can be high or low depending on the business operations. Care must be taken if this ratio is exceptionally high, because the company is either servicing a large amount of debt, or it does not need investors (Equity) after all.
Positive Cashflow: The company must generate cash from its operations to pay debts, dividends, etc. This can be determined from the statement of cashflows. Extra care must be taken when a company promises to pay high dividends but generate negative cashflows.
Profitability
Income Statement: In general, if a company is consistently profitable, it will improve the share price in the long run. The profitability of a company can be determined from the income statement. There are a few basic things to note. Firstly, a increasing trend must be observed. Consistency is the key word here.
Secondly, the sources of income must come largely from its organic business. Most businesses have "sideline" investments nowadays, and I wouldn't be surprised if they have more income from their investments than their core business. However, if that's the case I would rather invest in a holding company.
Thirdly, beware of goodwill. I honestly do not know why it is in the Income Statement. But goodwills are premiums paid when the company acquired another company, and they are not tangible. Be especially careful if the goodwill is reported in very large amount, relative to the company's assets and liabilities.
EPS: EPS is important because it essentially says how much earnings each shares is "making" Compare this relative to the share price, i.e EPS/Price, we get the Earnings Yield, which is the proportion of the price of the share that is attributed to the earnings. The inverse of this ratio gives the P/E ratio, the very popular ratio for investing, but IMO it must be used with other metrics to be useful.
The idea of value investing is to piece all the information that one could get to tell a story of a company. Some metrics are suggested here, but there could be more. However, too much information can be paralysing and therefore use only what is required.
Next up would be something on efficiency!
Stay tune!
~yZhiFa
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