Warren Buffett is famous for establishing the fundamentals associated with value investing. This approach involves using advanced financial metrics to determine if a stock is undervalued. Ultimately, a stock is deemed a bargain-buying opportunity if its current market price is listed below its intrinsic value.
Unfortunately, intrinsic value is loosely defined. Financial experts have numerous definitions for intrinsic value, with price-to-earnings ratios and other growth metrics being some of the common measurements. In today's volatile market, stock values shift drastically, placing importance on investor reactions to earnings reports, social media rumblings and any type of sentiment that can influence price movement. The following items are worth noting when considering the purchase of a stock based on value investing techniques.
A company looking to build a consistent reputation pays regular, quarterly dividends. These periodic payments reward shareholders, but there is considerable debate regarding their impact on investor sentiment. On one hand, a dividend shows healthy earnings, as companies issue payments out of their regular profits. At the same time, some experts believe that companies paying dividends should reinvest the funds back into the organization.
As of December 2015, several companies with a history of profitability have slashed dividend payments. Once considered value investments, both Kinder Morgan Inc. (NYSE: KMI) and Freeport-McMoRan Inc. (NYSE: FCX) have made considerable dividend cuts. Kinder Morgan, once issuing 51 cents per share, has recently issued dividends at just 12.5 cents per share. McMoRan has suspended dividend payments altogether. Value investors, who generally regard only certain financial ratios, should always take current dividend structure into consideration.
One of the general rules of thumb is to assess the dividend payout in relation to the company's total earnings. A benchmark figure for an established company with a history of dividend payments is 40%. Any ratio above or below this threshold should trigger further investigation. Debt is another factor worth mentioning, with regard to financial performance. An organization consistently paying dividends and neglecting its liabilities is not sustainable in the long term.
Cash Flow Analysis
Value investors too often pay attention to profits or earnings figures. Profit is one of the primary figures utilized in several of the value investing ratios, including the price-to-earnings ratio. Bear in mind that net income is merely a financial reporting figure. Certain metrics, such as free cash flow, strip out any receivables or money owed, thus painting a true picture of a company's overall liquidity. Value stocks that show a track record of earnings do not necessarily utilize cash properly.
For publicly traded companies, investors can access cash flow information from the most recent financial statements. Public companies have reporting requirements so that investors can analyze performance and make investment decisions based on this available data. As of 2015, several companies, including Time Warner Inc. (NYSE: TWX) and the J.M. Smucker Company (NYSE: SJM), have shown reputable growth in free cash flow. The lack of cash flow analysis incorporated into value investing strategies is noteworthy when researching value stocks.
Value investors are known to have a wide horizon. With market volatility inevitable in the financial market, it is critical to evaluate a security or stock based on its historical outlook, as opposed to recent trends. Certain companies, especially those in the media sector, have recently seen their stock prices plunge due to uncertainty related to the future of outlets, including cable television. Value investors can take situations such as short-term price drops as a perfect buying opportunity, since metrics point to the stock trading at a point below its intrinsic value. Turbulent periods can create a spending frenzy for value investors, causing them to neglect the peripheral financial metrics. One such stock to approach cautiously, which causes value investors to purchase prematurely, is the Walt Disney Company (NYSE: DIS). Recent reports in the media have questioned its sustainability, given the evolving landscape of media outlets.