Note: I am not an investing professional. The following method is not intended to be taken as financial advice.
In keeping with my investing studies, I've been working on an approach that helps simplify, at least for me, the value investing approach. In the traditional value investing approach (a la Warren Buffett), you are looking for stocks (or businesses) that are selling at discount to their intrinsic value - i.e. the value any rational business owner would pay for a business based on the future cashflows that business would pay that owner.
Because stock prices over the long-term tend to reflect the intrinsic values of the underlying businesses, when you buy stock at a discount (30-50% below intrinsic value), you will benefit from the eventual increase of the stock over the long-term.
The problem I've always had with this understanding of value investing is in calculating intrinsic value. Calculating intrinsic value relies on forecasting the cashflows of a business over its lifetime, which is incredibly difficult to do. It relies on a number of assumptions, including the growth rate of the company's earnings or cash; the discount rate, etc.
To help deal with this challenge in a way that makes more sense to me, I've developed the following approach to investing. Instead of thinking of purchasing stock as purchasing a piece of a business, I like to view stocks as products whose value must be assessed based on my wants or needs as a customer. In other words, I approach stock purchasing as a customer would approach buying a consumer good, like a smartphone or dishwasher or whatever.
As such, here are the steps to my approach:
For example, let's say you want to invest $10,000 (bankroll). You want to invest this money for 15 years (time horizon). At the end of that 15 years, you want to have $60,000 (cash-out value). Let's say you're interested in ABC stock, which is currently selling for $2.00 per share. $10,000/$2.00 gives you 5,000 shares.
If you want $60,000 by the end of fifteen years, then the share price will need to rise to $12.00 per share ($60,000/5,000). That is an annual rate of growth of 12.69% (MAG rate).
The next question you must ask is: How well-positioned is ABC company to take advantage of and/or develop market opportunities in order to justify this 12.69% annual increase? Some key questions to ask here include:
These are just a few questions you can ask. If your answers are mostly positive, then ABC company may be a good buying opportunity.
This approach makes two main assumptions. First, it assumes that the stock price will grow at a similar rate at which the company is growing earnings or equity. This growth will likely not be linear, but instead will likely be volatile. But it should occur over the long-term. As such, this approach is not a good for short time horizons (I'd say less than 7 years).
Second, it assumes that a company that is currently well-positioned to take advantage of or develop opportunities to increase earnings or equity will do so. It is my belief that for long-term success, positioning is key. A company that has key capabilities and resources to jump on opportunities very quickly will have an advantage over other companies with less capability or resources. Over time, in a brutal competitive environment, luck plays less and less of a role in the company's staying power.
The main benefit of this approach is that it does not give recourse to the concept of intrinsic value. The value of a stock is always relative to an investor and his goals. Ultimately, what I look for is not a stock selling at a discount to intrinsic value, but for a stock that can help me achieve my financial goals.
Following from this, it also doesn't give recourse to the concept of being undervalued or selling at a discount. We don't particularly need to know why a stock is selling at a certain price. All we need to know is whether, from its current price, it can reasonably grow to a higher price. The value is in the rate of return, not whether it is selling at a reasonable price.
Of course, this doesn't mean the process is easy. The most difficult step is step #7. Determining whether a company is well-positioned to take advantage of and develop market opportunities involves research, analysis, evaluation of the company, the company's industry, and the opportunities available. Going into this process is beyond this article, but I'll probably write more about how I think about it in the future.
Lastly, this approach is not designed to exclude or make irrelevant the intrinsic value approach. In fact, I might suggest using the product approach to complement the intrinsic value approach. It's always good to have an idea of intrinsic value as an anchor to compare the current share price to.
What the product approach does, though, is focus on the return rate for your investment. It forces you to confront the question: is it realistic to believe that the current share price can and will grow at the rate you require? Answering this question requires looking at the competitive positioning of the company.