This is the twenty-six Course in a series of 38 called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant / mentor.
Course 406 - Using Internet Sources for Research
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.
These Courses should help you 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.
The market may not always agree with your long-term investment philosophy, so sometimes even my recommendations are out of step with consensus thinking. (just joking)
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.
In this Course, I will generally share my approach to rating stocks so that you have an opportunity to benefit from my investment strategy and build enduring wealth in the market.
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.
I estimate a company's fair value by determining how much we would pay today for all the streams of excess cash generated by the company in the future. I arrive at this value by forecasting a company's future financial performance using a detailed discounted cash-flow model (see Course 403) that factors in projections for the company's income statement, balance sheet, and cash-flow statement. The result is an analyst-driven estimate of the stock's fair value.
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. Accordingly, I 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.
Prof's. 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?
Morningstar's stock star ratings are updated daily, and therefore they can change daily. 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. The Morningstar Rating for stocks includes a small buffer around the cutoff between each rating to reduce the number of rating changes produced by random market "noise." If a $50 stock moves up and down by $0.25 each day over a few days, the buffer will prevent the star rating from changing each day based on this insignificant change.
It is important to note that our fair value estimates do not change very often, but the market prices do. Therefore, stocks 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 (as we did in Course 108), 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.
I believe that 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, I 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. I believe that the value of owning stock is tied to how much value the company generates for its shareholders.
Thanks for attending class this week - and - don't put off doing some extra homework (using Google - for information and answers to your questions) and perhaps sharing with the Prof. your questions and concerns.
Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer
Text: Google has the answers to most all of your questions, after exploring Google if you still have thoughts or questions my Email is open 24/7.
Each week you will receive your Course Materials. There will be two kinds of highlights: a) Prof's Guidance, and b) Italic within the text material. You should consider printing the Course Materials and making notes of those areas of questions and perhaps the highlights and go to Google to see what is available to supplement those highlights. I'm here to help.
Course 101 - Stock Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios
Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality
Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting DCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill
Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips
This Completes the List of Courses.
Wishing you a wonderful learning experience and the continued desire to grow your knowledge. Education is an essential part of living wisely and the experiences of life, I hope you make it fun.
Learning how to consistently profit in the Stock Market, in good times and in not so good times requires time and unfortunately mistakes which are called losses. Why not be profitable while you are learning? Let me know if I can help.