How to Evaluate The Quality of a Stock for Long-Term Value Investing

Value investing is an investment strategy which generally involves buying stocks that trade for less than their intrinsic value. As such, value investors actively seek to buy undervalued stocks, mispriced by the market, in the hopes that the market will catch on and give an opportunity to profit. Rather than seek for quality, it is human nature to buy the market dregs and hope for heroic rebounds forgetting that a bad buy will eventually translate to a bad sell.

So you are now probably wondering, how can we identify quality stocks i.e. wonderful companies? After all, a stock isn’t all about the price you see but rather a whole value-creating machine with cogs churning every day. You can start off by seeking out the answers to several of these questions which are based on the value tenets by Warren Buffet. According to the value tenets, a stock must be:

Stable and understandable
Have long-term prospects
Be managed by vigilant leaders

Be undervalued

Here is a breakdown and the questions you’ll need to ask yourself as you determine stock quality:

Rule 1: A Stock Must Be Stable and Understandable

Stability is important in determining a companies value as a steady growing company is always ideal for long-term investors. Ultimately, we would like to see a steadily increasing book value, steady or declining debt/equity ratio and growing earnings per share. Will all these things to look, you’ll need a company that is understandable. This way you will be able to understand how any change in strategy or product will affect earnings. This way, you can make a good decision on whether to either buy, hold or sell.

Has the company avoided excess debt?

Warren Buffett would like to own a company where earnings are being generated from shareholder’s equity as opposed to borrowed funds. We use the debt/equity ratio to asses this as it shows the proportion of equity to debt the company is utilizing to finance its assets; higher ratio signifies for debt rather than equity. High debt level compared to equity can result in volatile earnings and high-interest expense. To tighten the noose a little, consider only long-term debt as opposed to total liabilities in your computations. The Debt to Equity Ratio is calculated as follows:

Debt/Equity Ratio = Total Liabilities ÷ Shareholder’s Equity

Note: A steady or declining Debt/Equity ratio that is below 0.5 is ideal

Rule 2: A Stock Must Have Long-Term Prospects

For value investing to be successful, a stock must have long-term prospects. The ability of a firm to survive over time relies on various things: (1) competitive advantage; and (2) growth/sustainable profits. Companies with long-term prospects must continue growing and generate sustainable profits, as we have established in the previous section.

Do the company products rely on a commodity?

Warren Buffett considers this a very important question as he tends to avoid companies that have products/characteristics that are indistinguishable from their competitors or rely solely on commodities such as oil and gas. The aim here is to buy value and there is more value in purchasing companies whose characteristics are hard to replicate – commonly referred to as economic moat or competitive advantage. The wider the moat, the tougher it is for competitors to gain market share and annihilate it.

Rule 3: A Stock Must Be Managed By Vigilant Leaders

Even as a novice investor, you can easily assess the quality of management using two-yard sticks: (1) how well they have run the business (2) how management has allocated capital over time.

Are profit margins high? Are they increasing?

To achieve assess the first yard-stick, we will need to look into profitability. A companies profitability relies on two things:(1) profit margin and, (2) consistent increase in profit margin. Profit margin is computed by dividing the net income by net sales. A get a good picture of the company, go back at least five years and assess the year on year profit margins. A high-profit margin is a sign that the company is executing its business well and increasing margins means that the company is efficient and successful in controlling its expenses.

Additionally, profitability needs to also be assessed in comparison to the competitors. How what has the competitors accomplished – changes in market share, expenses levels and also the competitive advantage.

Does the Company Have Any Growth Prospects?

One of the most important responsibilities of a company’s management is capital allocation. This is the decision of where to deploy a firm’s access capital. As investors, it is our job to ensure that management is making intelligent decisions for capital allocation as it has a great effect on long-term investment returns. The easiest and simplest way to proxy returns from investments why multiplying the company’s reinvestment rate by the business’ return on capital.

Return on Investment Capital

Return on capital measures the return that an investment generates for capital contributors across the board, i.e. bondholders and stockholders. For example, if a business reinvests 50% of capital at a 20% ROIC, then a 10% incremental return can be reasonably expected on the investment you make.

Return on Investment Capital (ROIC) = (Net Income – Dividends) ÷ Total Capital

Most importantly a business does not need to have strong growth prospect through reinvestment of capital within its ranks to generate value for investors. There are some businesses out there that are stagnant but still making solid investments in other areas. With such companies, what you need to look for is:

It’s excess free cash flow generated that can be invested elsewhere
Its strong competitive position and the unlikely to deteriorate in the near future

It is important to keep in mind that many businesses have no choice about whether or not to reinvest, i.e. capital-intensive firms that must reinvest all their cash flows just to maintain the current competitive position. A great example of such a company is KQ. Also, there are other areas of capital deployment mergers & acquisitions, debt repayments, dividend payments and share repurchase decisions. All these encompass the vital capital allocation decisions that management make at a more complex level.

Overall, as investors, it is our job to ensure that management running our company makes the best use of our capital to maximize our returns. Which brings us to the next question, what is our return on equity?

Has the company consistently performed well?

Here we look at the return on investment for shareholders which is depicted in the Return on Equity (ROE). The Return on Equity measures the rate at which shareholders income on their shares. Buffet uses it to assess whether a company has consistently performed well when compared to other companies in the same industry.

The Return on Equity is calculated as follows:

Return on Equity (ROE) = Net Income ÷ Shareholder’s Equity

Rule 4: A Stock Must Be Undervalued

This is the most difficult assessment you’ll have to make as you’ll have to determine the company’s intrinsic value. The problem lies in the fact that a company’s intrinsic value is usually higher than its liquidation value. Liquidation value is the actual worth a company is sold for if it is broken down and sold for parts – does not include intangible assets i.e. brand.

Is the company stock selling at a 25% discount to its real value?

Notwithstanding, we can still try and estimate a company’s value using various company fundamentals – earnings, revenues, and assets. With this estimation, we measure it against the market capitalization (current total price) and only move ahead if the value is at least 25% higher than the market capitalization. Warren Buffett has gained a lot of success in estimating a company’s value. Here is a there is two simple valuation technique that Warren Buffett uses to estimate company value:

Comparison of Market Value to Book Value – ideally trading at least 25% lower than the book value.
Price to Earnings and Price to Book Value Method as highlighted below.

Price to Earnings Ratio

The price to earnings is a measure of the current price share relative to its earnings.

Price to Earnings (P/E) = Market Price Per Share ÷ Earnings Per Share

Note:

A high P/E suggests that investors are anticipating higher growth

A low P/E suggests that the company is doing well relative to past trends
Companies with negative earnings have no P/E ratio

Price to Book Value

The price to book value is a measure of the price you pay for every shilling in book value of the business. The aim for every value investor is to have as much as possible in book value for every shilling since it is a measure for the safety of your investment.

Price to Book Value (P/BV) = Market Price Per Share ÷ Book Value Per Share

Where: Book Value per share = (Total Assets – Total Liabilities) ÷ Number of Shares Outstanding

Note:

A higher P/BV translates to low safety (typically above 1.5)
A low P/BV translates to higher safety (typically below 1.5)

A word of caution here, as you seek low P/BV, analyze all the company fundamentals for any signs of trouble. To be safe, compare the ratio with industry counterparts to know where the company lies.

Now we put the P/E and P/BV together by multiplying the price to earnings (P/E) with the price to book value (P/BV). The ideal product should not be higher than 22.5 as it is a strong indication that the stock might be undervalued. The reason for this is that low P/E indicates a high return, while a low P/B is an indication for high safety.

Summary

Again, these are the four rules for investing in stocks according to Warren Buffet. The aim is to buy for the long haul – 5 years at the very least. For this reason, we must pose some fundamental questions to test a companies resilience to withstand the market. Ultimately, we seek to buy a wonderful company that meets these criteria and only purchase based on what we think it is worth – not the market.

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