Our 5-step value investing process

Closed urban outfitter shop

As we discussed in our previous post, there are a lot of factors to consider when you start your value-investing journey. In this article, we outline our 5 steps to making a purchase decision. Ready? Let’s go!

1. Find industries within your comfort zone

The first step is to find companies that you are interested in investing in. One of the tips Peter Lynch gave in his best-selling book “One Up On Wall Street: How to Use What You Already Know to Make Money in the Market” is to find an industry that is close to your work or interests. In my short professional career, I have been working in the travel, finance, consumer goods, and advertising industry. These are the industries I know most about, and keep regular tabs on which makes it a great place to start. Are there any companies that you know perform well, but are out of the spotlight. Have you heard rummors of a potential acquisition of your favourite clothing brand by a bigger player? These are the starting point of finding hidden gems!

2. Indicate companies that might be undervalued

This step might be a bit harder. There are so many indicators of a good company by just looking at various ratios. Our personal favorite is the PE ratio. Considering that the market average PE ratio is between 20-25, anything under that might indicate a good opportunity so swoop it up in your portfolio. For this case study we will use Urban Outfitters ($COLM). At the time of writing this article, the PE ratio is around 18.0.

3. Check company financial health and foundation

Some important metrics to consider:

  • Has the company been growing their revenue?
  • Has the company been growing their net income?
  • Has the company been growing their net income?
  • Is the company’s long-term debt covered by their free cash flow?
  • Is the company diluting it’s shareholders?
  • Have they been growing their dividends?

Our tool will answer all these questions for you in a wink of an eye:

This by itself does not provide you with the full picture, but if you are searching for high-quality companies, this first step will tell you whether to keep investigating this company or move on! For the sake of this article, we will continue with Urban Outfitters.

The following questions you should now ask yourself are regarding the competitive advantage of the company.

  • Are they able to transform revenue into profits?
  • What is their interest expense ratio?
  • Does the company invest heavily into R&D?
  • Is it easy to sell the products, meaning, do they have a low Selling and General Expense Ratio?
  • Do they have a lot of inventory which is depreciating?

Again, our sheet does the math for you!

There is some good, some bad, and some ugly. First, they are not able to transform their revenue into profits, which leaves some room for the optimization of the business model. This is not what we are looking for, we are looking for businesses with good 20%+ Net Earnings Ratios.

The interest expense ratio is good. Research and Development Ratio of 0% is good. Any company with a Research and Development Ratio below 20% is considered good. This is because they have products and services that people want and they do not have to develop this further.

Selling and General Expense Ratio is a bit on the high side. This ratio explains that they need to invest on average 25% of their budget into marketing to move products. We would like this ratio to be below 20%.

The depreciation of gross profit margins should ring alarm bells. Urban Outfitters has an average yearly depreciation ratio of 21%! This might be an indication that they consistently have a lot of unsold items still in inventory.

4. Put a price on the stock

By now, I would probably have stopped investigating this company. But for the sake of this article, we will dive deeper into the valuation mechanics of our tool.

First, we need to know the average expected growth per year. We can find analysts’ opinions on Yahoo Finance. They estimate an average yearly growth of 27% for the next five years… I find that hard to believe. Looking at the average revenue growth of the past 5 years, they have increased their revenue by 6% which is probably more realistic.

Next, we need to find their average P/E of the past years. We can use Macro Trends to help us to estimate this number. Ignoring the outliers, they had a high PE of around 18, and a low of 8, which would give us an average P/E ratio of 13.

Our tool returns an average valuation of 22.71$, and a target buy price of 15.9 considering a margin of safety of 30%

5. Buy or pass on the stock and repeat.

In this example, we would probably skip on the stock. The company’s foundations are not attractive, and the current price is three times as high as where you might want to consider buying.

Concluding remarks

Does this process appeal to you? Good news, you can acquire our tool today!

About value investing

Man sitting on pile of cash learning about value investing

Value investing is a popular investment strategy that has been used by many successful investors to achieve long-term financial gains. In this blog post, we will take a closer look at what value investing is, its principles, and how you can apply it to your own investments.

Value investing is an investment strategy that involves identifying companies whose stock price is undervalued by the market. This approach is based on the idea that the market sometimes undervalues companies that have strong fundamentals, such as a strong balance sheet, healthy cash flow, and a good earnings history. The goal of value investing is to find these undervalued stocks and hold them for a long time until the market realizes their true value, resulting in a substantial return on investment.

Principles of Value Investing

Value investors follow several key principles when identifying stocks to invest in. These principles include:

  1. Margin of Safety: The concept of margin of safety is a fundamental principle of value investing. It means that investors should only buy stocks that are trading at a significant discount to their intrinsic value. This approach helps to minimize the risk of losses in case the market does not realize the stock’s true value.
  2. Long-Term Perspective: Value investing is a long-term investment strategy. Investors who follow this approach hold onto their stocks for many years, waiting for the market to recognize their true value. This is why value investing is often associated with a buy-and-hold strategy.
  3. Focus on Fundamentals: Value investors focus on a company’s fundamental metrics, such as its earnings, cash flow, and book value. They look for companies that have a strong balance sheet, a competitive advantage in their industry, and a history of consistent earnings growth.
  4. Patience: Value investors need to be patient. They are willing to wait for the market to realize a company’s true value, even if it takes several years. This requires discipline and the ability to resist the temptation to sell a stock too soon.

How to Apply Value Investing

To apply the principles of value investing to your own investments, you should follow these steps:

  1. Conduct Fundamental Analysis: Conduct a thorough analysis of the company’s financial statements, including its earnings, cash flow, and book value. Look for companies that have strong fundamentals and a history of consistent earnings growth.
  2. Determine Intrinsic Value: Use a valuation method, such as discounted cash flow analysis or price-to-earnings ratio analysis, to determine the stock’s intrinsic value. This will help you determine whether the stock is undervalued or overvalued.
  3. Assess the Margin of Safety: Determine the stock’s margin of safety, which is the difference between its intrinsic value and its current market price. Look for stocks that have a significant margin of safety, which will help protect your investment in case the market does not realize the stock’s true value.
  4. Monitor Your Investments: Keep a close eye on your investments and monitor the company’s financial performance. If the company’s fundamentals deteriorate or if the stock’s price increases significantly, it may be time to sell the stock.

Conclusion

Value investing is a popular investment strategy that has been used by many successful investors to achieve long-term financial gains. This approach involves identifying companies whose stock price is undervalued by the market and holding them for a long time until the market realizes their true value. By following the principles of value investing, conducting fundamental analysis, determining intrinsic value, assessing the margin of safety, and monitoring your investments, you can apply this strategy to your own investments and potentially achieve significant long-term returns.

Want to start value investing?

It can be daunting to start value investing, there are so many resources, platforms, books, and individuals with their own opinions on the topic. That is why we came up with a tool to help you! Our tool combines a few of your educated assumptions and years of knowledge we have gathered from research on the topic. The value that you will receive is a process that is fully rational and shields you from making irrational decisions during price swings and of course to identify opportunities. So what are you waiting for?! Get our tool today!

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