In the classic investment book "The Intelligent Investor," Benjamin Graham, who is considered the father of value investing, defines two types of investors. The first he describes as defensive, or an individual who prefers to invest in passive investments, such as index funds, or would simply rather hire an outside money manager to handle his or her financial affairs. The second class consists of enterprising investors, or those willing to take the "intelligent effort" to ferret out potentially profitable investment opportunities. This type of individual would surely benefit from knowing how to recommend a stock.
Determining a Stock's Value
Individuals interested in doing their own investing won't officially have to recommend a stock to themselves, but others who choose to manage money professionally will inevitably have to pitch a stock to either their boss or a client. In any of these instances, coming to a firm conclusion as to whether a stock warrants an investment is of the utmost importance.
Recommending a stock ideally consists of analyzing every important aspect of the company and then coming to a conclusion on if it is overvalued, undervalued or fairly valued. The first two instances could result in an opinion that could turn profitable. If a stock is deemed to be undervalued, then going long or buying a position will ideally pay off as it reaches its intrinsic, or true, value. On the flip side, an investor could short a stock deemed to be overvalued, which means betting on its decline to a lower true value.
Qualitative and Quantitative Factors
Returning to the analysis aspect, creating a comprehensive investment checklist is recommended. This will include qualitative and quantitative factors. Qualitatively, an investor should learn what the underlying company does and how it makes money. Its industry positioning, such as where it stands compared to peers and direct rivals, is important in determining whether the firm has a competitive edge over the competition. Other important qualitative factors include an overview of key customers and suppliers, and whether the company is in the start-up, growth, maturity or decline phase, which may be broken down by its different products and services. Overall, an investor should evaluate the company's growth prospects going forward.
Quantitative factors are vital and can be broken down into two key categories; the first consists of the company itself. For instance, analyzing its historical track record is important: how fast has it grown sales, profits and cash flow? This should be broken down into the last quarter, past year and longer periods, such as over the last three, five and 10-year periods. Performing a ratio analysis is also ideal and should look at financial strength, profitability measures, efficiency ratios, as well as management effectiveness. Examples in each of these categories include debt to equity, operating margin, revenue per employee and return on equity.
The other key important quantitative measures to look at consist of breaking down the company's investment appeal. Valuation measures, such as enterprise value to sales, price to earnings (P/E), price to cash flow and price to book value, could prove very useful. The investor will also want to perform a similar analysis for comparable peers to get a feel for how the company in question stacks up. A lower P/E compared to peers could indicate the stock is undervalued, for instance.
More sophisticated valuation techniques include performing a discounted cash flow analysis, or DCF to discount the future estimated cash flows back to the present day. Adding them up will allow the investor to estimate an overall value for the firm, which can be used to estimate the intrinsic value of the stock price. Similar techniques again include a comparable analysis of other rivals, as well as the prices that peers might have been bought out for and at what valuation measures. With any luck, the recommended stock could be undervalued and trade closer to levels of peers, or be bought out at a premium closer to comparable deal transaction levels.
The Bottom Line
There are many other factors to consider when recommending a stock. For instance, the quality of the management team, as well as how it treats shareholders and helps them grow their wealth, are important. There are also plenty of industry-specific quantitative ratios and measures to consider for companies and their rivals. But the above overview covers the nuts and bolts of performing a thorough analysis and learning how to recommend a stock that will ideally turn into a very lucrative investment.
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