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Famous investor Warren Buffett is known for identifying which stocks are undervalued or selling for less than their true value.
But how does he identify which stocks are undervalued? And how can you do the same? Here’s what you need to know about undervalued stocks.
intrinsic value
To find stocks that are selling for less than their worth, you first need to determine how much they’re really worth. Buffett called this intrinsic value.
“If we could look at a business and see what the future cash inflows or outflows from the business or from its owners would be over the next number of years, we would call it a hundred years or until the business goes extinct and then discount that at an appropriate interest rate, which would give us a number for the intrinsic value,” Buffett said. 1997 Berkshire Hathaway shareholder meeting.
margin of safety
Once Buffett estimates the intrinsic value of a company, he discounts it by 30% or more to the price he is willing to pay. This margin of safety reduces his risk.
competitive advantage
Forecasting future cash flows involves some crystal-ball predictions. But figuring out what a business’s cash flow will be in 10 or 20 years involves more than just looking at what it’s done so far. Buffett also pays attention to the company’s competitors to ensure that his target company has an advantage that cannot be easily replicated. He wants to ensure that the companies he buys will remain a top choice for consumers.
circle of merit
Buffett only invests in businesses that operate in industries he understands. For years, Buffett avoided tech stocks because he said he didn’t understand what the companies were doing. Understanding the business his target companies are in helps him evaluate them more objectively.
Applying Buffett’s Methodology to Your Investing
When looking at your own portfolio, you can apply Buffett’s strategy to your purchasing decisions. Identifying intrinsic value may be the most complicated part, but help is available. Take a look at analysts’ expectations for the next 12 months and review the company’s recent earnings call for a long-term outlook. And be sure to consider the competency cycle. Do you understand how the business makes money and do you think they provide a good product or service?
Applying Buffett’s strategy to your investing doesn’t mean that every stock you choose will be a winner. But by copying their disciplined approach, you may find that you’re doing better than other people.
Editor’s Note: This article is for informational purposes only and does not constitute financial advice. Investing involves risk, including possible loss of principal. Always consider your individual circumstances and consult a qualified financial advisor before making investment decisions.