When we all first learn about investing we are introduced to the two classes of investing that almost everyone fits into. One of the most important thighs you can do is understand the basics of how they work, and determine what strategy you think will fit better into your long-term goals. Both are wildly different and so I hope that this basic guide can help clear some things up!
Value Investing
This strategy involves purchasing shares in established companies with stable future growth expectations. This traditionally entails rather boring companies servicing basic human needs like construction, food or banking. These companies generally trade at low multiples in comparison to their earnings and are banking on certain strong secular trends that will enable them to grow along with the economy. This is necessary because since they aren’t disrupting anything, they need the underlying economy to grow. This basket of stocks is much safer than the alternative and generally pay dividends to shareholders in order pay them back for the money they invested in the company. There are 4 things I look for with any value stock (though of course the required research is much more than just that):
1. P/E (Price/Earnings), Forward P/E...
I want to see preliminarily how much the company trades for in relation to the amount of money it makes. Of course, higher values are worse and so this is also a screener, since some stocks like sherwin williams (a paint company) trade for 30 times earnings despite only growing about 5%. This is because of their perceived safety, however, these types of valuations aren’t the best for capital appreciation.
2. Comparing it to Industry:
The next step in the valuation process is comparing the general valuation ratios to the industry and seeing how & why the company is trading in relation to its peers
3. DCF Valuation Model:
The other main step conducted in valuing the company is going through a DCF model. This is the be all & end all of valuing a company since it estimates the sum of all the company’s current and future earnings, essentially consisting of everything that the company will produce. The most basic model involves inputting certain estimates for growth, and determining what return you require to invest (more advanced models involve the WACC). This will give you the total earnings produced and you can then discount that by your required rate of return to account for the time value of money (formulas below). You then compare the value achieved to the company’s market cap, and the difference is the margin of safety - this is important because all of your assumptions are likely to be somewhat, if not very wrong, and this helps you hedge against that.
When considering assumptions for growth rates, you can be relatively optimistic with the first 5 years, and you should be more conservative for the next 5 years after that. You cannot assume that every company will keep the same growth it has now for 10 years - not every company will be Google or Amazon, you have to be relatively conservative. The terminal growth rate represents how much growth a company will have forever. This means that the long-term growth rate must be lower than your required rate of return, or it would become infinitely big. Also, it means that your value needs to be very conservative, with any number above 4% being arguably too generous - keep in mind the timeframe is forever. This is why the strategy works best for reliable companies, since their cash flows and growth rates are very estimable.
In terms of your estimates, you can add more years of forecasted growth to the 10 I list here. This can be especially useful for stocks like the aforementioned Amazon that are likely to grow at much more than 4% even 10 years from now.
4. Moat & Business Model Strength:
The final important thing to remember is that the company needs to have a strong moat & a good business model with long-term growth potential. We touched on this before, but you want companies that you can reasonably assume will grow a certain amount for a very long time, and that have a low ability to be disrupted or out competed. This can be something like a brand (Coca-Cola), or massive capital expenditure requirements (AT&T).
Growth Investing
This investment style surrounds one key idea. If you buy companies that have revolutionary and disruptive technologies, they can grow enough for long enough that they will eventually make enough profits to justify their valuations. This investment style is incredibly risky, as for every Google and Amazon, there are dozens of failures. This risk is currently being exemplified by the markets as tech stocks plummet, some over 80% from the highs. Why is this? Well, when you make exorbitant assumptions for the growth of a company, you can get massive changes in its value as those assumptions slightly change. When looking for a growth company there are 2 basic things you need to look out for:
1. Business Model & Disruptive Capabilities
The company needs to have an excellent business model that is disrupting a massive industry or changing the way that people live. Why is that? Well, if you are investing in a company because of its long-lasting potential growth up to 30 years from now, you need to know that there is a massive runway for it in order to justify those assumptions. Essentially, you need to have a business that is exciting enough that you can assume substantial long-term growth. The business also needs to be valuable enough that prices can eventually get high enough for the company to realize sustainable profit margins. Since most of these exciting companies are unprofitable, there needs to be the assumption that the service is valuable enough to charge such that they can make profit.
2. Valuation Vs. Speed of Growth
The company also needs to be, of course, growing fast, but growing fast at a fair valuation in relation to its peers for the eventual profit to make sense based on the price you are paying. Too many investors get caught up in the exciting story and forget that at some point, real results are needed. This exuberance is exactly how a company like Tesla could achieve a Market Cap that was larger than its next 6 competitors - suggesting it would own the vast majority of the car market eventually…
3. Checking if the Growth is fairly Valued with an Exit Multiple Analysis
Valuation & business potential/sustainability are all that you really need as a basic growth investing strategy. However, to evaluate if your thoughts make sense you can set up a forecast model called an exit multiple strategy:
Essentially, you forecast the expected revenue growth rate for your company for the next five years and then do the same for the next 5 years after that. You then determine what kind of net income margin the company will be able to achieve 10 years from now. Finally, you determine what kind of Forward P/E the company would trade at based on its growth rate 10 years from now & compared to similar companies. You then determine your required discount rate and discount the value based on the number of years you’ve projected. The market cap generated can be compared to the current one to determine your margin of safety.
Of course, there is tons of variability in this since you can extend your forecasted period to 15 years, or decide you can only see 5 years in the future. Also, the net margins and all the growth rates are all subject to a lot of assumptions.
Wrap-Up
All in all, I hope you can all see why most investors can have a super tough time making money, and especially outperforming the market, since the objectively correct ways of valuing a company all depend on ever-changing assumptions. These assumptions are also easily affected by the limit of the market opportunity - you have to pick companies that are likely to be able to grow 15%+ for over 20 years and still have opportunity left, something that not many companies actually realistically have…
This is of course not even close to a complete guide on how to buy stocks, and even the best investors still get it wrong sometimes. However, I hope that this is a good introduction to the art of investing, what it entails and some basic strategies.
Main Formulas
Terminal Value: (Terminal Earnings * (1+terminal growth rate))/(Required rate of return-terminal growth rate)
Discounted Current Value: Sum of all projected earnings for 10 Years and Terminal Value divided by the required rate of return ^ # of years that you projected (in my case 10)
By: Mateo Gjinali
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