The key to making money from shares, at least in my opinion, is to buy shares in companies with the greatest potential for capital appreciation and the least risk of capital loss. This may sound like a like a relatively simple strategy - and it is. But that doesn't means it's easy.

In this article I'll discuss one of the strategies I employ when trying to find a bargain. And just as importantly, I'll point out the sort of situations I try to avoid.

Some of the greatest stock market investors the world has ever seen have made their fortunes hunting for bargains.  Benjamin Graham (the father if value investing), Walter Schloss, Bill Ruane, Irving Kahn and of course the great Warren Buffett have all made themselves, and those whose money they managed, outstanding profits over a long period of time.

By and large these money managers were bargain hunters.  They looked for value and a margin of safety.  They looked for companies which were unloved by the market and therefore had low share prices relative to some objective measure of value.  They also protected themselves from loss by only entering situations where there was a margin of safety - where if things didn't work out as planned, the price paid was low enough to make significant price declines from that point unlikely.

So how do we go about finding these bargain basement opportunities?  One of the simplest methods to employ is to look for companies where the share price net cash backing per share.  There are many variations you can employ here.  I believe that Benjamin Graham employed a measure called Net Cash Asset Value (or NCAV) which is essentially what we're talking about here.

The essence of this strategy is to find out the amount of cash and cash equivalents a company has after subtracting all liabilities, both current and non-current, then divide by the number of shares on issue.  This in theory gives you the liquidation value of the company on a per share basis - the amount which would be realized if the company was wound up.

What cash and cash equivalents are made up of is sometimes a contentious issue.  Obviously cash at the bank should be included.  Beyond that, you need to use your discretion.  Short term investments in marketable securities could probably be included (perhaps at a small discount to allow for potential market fluctuations).  Receivables (money owed to the company) if included, should be discounted to take into account the risk of default.  Stock on hand once again should be discounted (if included at all) to reflect the fact that heavy discounting might be required in order to clear the stock.

What you include or exclude in your calculations will be a little subjective.  For example, depending on the nature of the business, stock on hand be be marked down to zero.  This might be the case where the industry is very specialized with very few buyers.

Ultimatelty what you're looking for is a conservative value of what the shares would be worth if the business closed its doors and ceased operating today.  The theory here is that once this should provide a floor to the share price.

When you're looking for businesses which meet these criteria, you need to be aware that types of companies you'll typically come across are at the smaller end of the market and are inherently riskier.  We're hoping to mitigate this risk by not paying too much for its shares, but diversification is also is also important.  I try to find a number of these situations and spread my investment across them all.  That way if one of them goes bad I haven't lost everything and hopefully the aggregate gains across the portfolio will more than cover the loss.

One other thing to consider is that the balance sheet (which is where the figures for your analysis will come from) is a point in time snapshot.  It captures the financial position of the company at the end of the reporting period.  What I try to do is get a feel for how the business is changing over time.  Is it losing money?  If your margin of safety is wiped out by 6 or 12 months of losses, then it's probably not the bargin opportunity you thought is was.

Like most other people I've had my share of ups and downs investing in Australian shares.  One of my successes was an investment in Biota Holdings many years ago.  When I bought them, they had a heap of cash and no debt.  I can't remember what the reason was but the market had just fallen out of love with them.  I managed to buy at less than two thirds of the cash backing per share.  The only downside was that they were losing money at the time as they were spending money of their drug research but didn't have much in the way of income.  But at the cash burn rate they were reporting at the time, they could afford to operate for a couple of years before the gap between share price and cash asset backing was wiped out.  On the plus side they had a number of drugs in the pipeline and only one success (or even a rumor of success) would see the share price shoot up to many multiples of where it was.

Sure enough, within a few months the rumor mill fired up and the share price doubled.  I sold half of my holding.  Then because of the recent share price action, it caught the attention of some stock brokers and a prominent investment newsletter publisher and subsequently doubled again.  I promptly sold the rest of my holding.  There was still significant 'blue sky' but my margin of safety had just evaporated.

The share price continued to climb even with no announcement from the company.  Who said the Australian stock market is efficient?