What is Cash Yield? | What is Intrinsic Value?

Before You Buy

last updated

You've found a stock with a great history of real earnings growth—and it's on sale! You're ready to click your mouse to buy some shares. Everything's great, right? You're all set, right?

Hang on! Before you buy, make sure you know the stock's story (What's a story? See One Up on Wall Street or The Peter Lynch Approach for more details.)

What are the Assumptions of Value Investing?

Value investors can get a lot of mileage out of analysis such as free cash flow analysis and discounted cash flow. You can find great bargains in the stock market if you look. Yet every projection rests on two assumptions. First, that great companies make money and grow predictably. Second, that an over- or undervalued stock price will eventually reflect the true underlying value of the company.

The good news is that less than an hour of research help you answer that question. You've already ruled out thousands of stocks. Now you can choose between three or four good possibilities. In an afternoon you can decide what you really should buy. Here's where your story lines come in.

How to Research a Company Before Buying Stocks

The stock's story is really very simple. How will the company make more money? To answer that, you have to learn a few things about the company.

What does it sell? Who are its customers? How often do they buy? How much work is it to get new customers or to keep existing customers?

What's the market for the product or service? Is that market growing or shrinking? Are there similar markets to enter or leave?

How much competition does the company have? Is it easy for competitors to enter the marketplace? What advantage does the company have over competition? (A brand name, expensive factory, important people or inventions that are difficult to reproduce, prime real estate.)

How much further can the company grow? How much does it cost to expand? A small company can double in size much more easily and quickly than a huge company; that's why stocks like Facebook have limited growth potential compared to plucky little startups.

Are there any obstacles in the way of growth? (Regulatory issues, management scandals, risky ventures.)

Who manages the business? How long have they been there? What's their background? Where were they before? What's their philosophy? You can learn a lot by looking at the track record of paying dividends or buying back stock.

When Should You Buy a Stock?

If you've done your homework and found a storyline to explain how the company will produce real value, you have to see if it's plausible. Your story has to answer only one important question: can the company really meet your expectations over the next five or ten years? What could go wrong? What has to go right? You don't have to predict the future in complete detail, but your story needs to hold together.

If at any point you start seeing red flags and think "Wow, this potential for growth seems unlikely," stop. Move on. The story must seem plausible to you. If you don't understand it and if you're not comfortable with it, don't invest. There will be other opportunities. There are always good opportunities for the patient.

The story doesn't have to give you complete confidence that the company will do exactly as you expect, right down to the penny. Stocks go up. Stocks go down. In the short term anything can happen. You only have to be able to understand it and believe that it's sensible.

After all, you're buying part of a business. You want a business you understand, a business that can grow, and a business that will make real money. Those are the stocks to buy.