Monday, 4th October 2010

The Art of Stock Valuation, part 1

Written by George Traganidas Topics: Stock Investing, Wealth Building

When you are looking to invest your money in the stock market you need to go through thousands of companies and decide which ones will prosper in the future and which ones will not. The way to decide which ones will prosper is more of an art than it is science. Unfortunately, there is no secret formula for this although many people have tried unsuccessfully to create one that will work over the years. Many of these theories have been created based on mathematical models and all of them failed in due course.

This series of posts will look at people who have been successful at picking prosperous businesses over the years and will try to reverse engineer their successful approach. We will look at both quantitative and qualitative measures that can be used to evaluate companies. The data available for each of these companies is so vast that we need to sort through it, ignoring the noise and concentrate on the key metrics that really matter.

Another obstacle in the way of successfully valuing companies is that there is no uniform way to analyse them. Each company is so unique that we can not reuse the same approach we have applied to one for another. We will try to create some general themes in the way that we look at companies so we can reuse certain aspects of our approach across the board.

We will create a checklist with certain criteria that will be applied to each potential company. This checklist will help us to keep track of our analysis and not forget important aspects that come back later to haunt us.

The major thing to keep in mind is that in order to value a company you must estimate how this company will perform in the future. This is a challenge as no one knows what the future holds and thus our analysis can never be 100% complete and accurate. We can only have a certain degree of confidence that our analysis will hold. This means that we will not try to be extremely precise in the analysis but we will to look at ranges of potential future outcomes.

Keeping the uncertainty of the future in mind we need to use a margin of safety. Knowing that we can be wrong about our calculations and the future of the business we need to define what is an acceptable risk level. This will protect us if our analysis is wrong and it will also help us to maximise our profits if the analysis is correct.

Follow the practical way,
George Traganidas

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