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Long-term investing: Finding value in 3 value signs of stocks

Updated on January 31, 2012

Long-term investing... value signs to look for in stocks

So, you want to be the next big value investor (step aside, Warren Buffett). Well, the following notes are intended as a reference tool, to help you know where and what to look for while examining new stocks. So, how should you make these long-term investment decisions? Below I have compiled a list (which I wrote up and presented on to my investment club), which I believe to be the most important things to look for if you are a value investor. The notes are based on Kiplinger’s “Invest your way to wealth” by Theodore J. Miller and the "Consumer Reports Money Book: How to Get It, Save It, and Spend it Wisely" by Janet Bamford, Stacie Zoe Berg, Jeff Blyskal, emily Card, Aileen Jacobson, Greg Daugherty and the Editors of Consumer Reports. Both are excellent books that I would highly recommend you take a look at...

I would especially recommend The Consumer Reports Money Book to all of you younger readers. I bought it my senior year of college, read it cover-to cover, read it again, and still refer to it now. It covers virtually every aspect of personal finance you are willing to face in your life, and has definitely paid for itself 1000 times over.

Earnings Growth

Value sign #1: Earnings Growth

 Earnings growth is a way to quickly separate the starting players from the bench players. Sure, a bench player can come in and rally his team with a couple of knock-down three pointers, but there is a reason he is a bench player... he's streaky... you can't count on him day in and day out. On the other hand, your starting players are strong and consistent. Maybe they are not flashy, but they get to the hoop, get fouled, and then sink both of their free throws. If you are not a basketball fan, I am sure I totally lost you on that analogy, so let me be clear. Stocks with strong earnings growth (aka: our starting players) show the investor that they are growing and since the best indicator of the future is the past, we should make sure that the stocks we pick have this solid growth. Speculative stocks (aka: bench players), can be a good investment if you are very well informed, but they can jump up and down quite a bit, which makes them very dangerous. Sure, the idea of doubling your money based on tip from a friend of a friend of a guy who knows a guy can be enticing, but long-term this strategy will only lose you money. So, be sure to look for stocks with a consistent pattern of long term growth.The length of the consistency is up to each individual investor, but most experts would agree that five or more years of consistent growth is a very good indicator of the long-term value of the stock.

P/E Ratios

Value sign #2: P/E Ratios

P/E ratios indicates the price of a stock divided by its earnings. This ratio basically shows the investor what other people are willing to pay for it based on it's expected future growth. Price/earnings is a key measure of its value because it weighs what people think it is worth at that given time. A lower P/E ratio shows that the average investor does not see much additional room for growth. These types of stocks have generally been around for a while and will not likely see explosive growth over the short-term. But, as a value-investor you don't really give any thought to short-term growth profits. Stocks with high P/E ratio's indicate that the investment community believe that the growth prospects of that company are very high. Of course the risk of loosing money is also higher with these stocks. Kiplinger advises investors to look for companies with P/E ratios ranging from 10 to 13 (this is just a good starting point to start looking… some industry’s will have lower ratio’s as a group, and others will be higher. The key is to look at the industry as a whole, which you can use as a comparison as well as comparing the industry leaders against each other.) High/new tech stocks tend to have higher ratio’s because investors believe that these types of company’s have lots of room to grow, whereas, bluechips, utility, and energy stocks generally have a lower ratio because investors don’t believe there is as much room to grow (these types of stocks also generally have dividends paid out to shareholders to make up for lower growth potential). The main reason I like a low price compared to earnings is because there is less room for a drop off in stock price, and investors are less likely to get out of a stock because of unfavorable (to some extent) news, while stocks with high P/E ratios can drop considerably based on such news or even on unfounded (sometimes even purposely leaked and untrue) speculation.


Value Sign #3: Dividends

Dividend yields are a great way for investor's to profit through long-term investing. Dividends are basically the investors share of the earnings of a company. Quite often you will find that stocks that historically and consitently raise their dividends will continue to do so. A value investor will look for these stocks that show growing dividends because it indicates that more increases could be coming. However, investors should be wary of dividends that are TOO high. An investor has to do his/her homework and be sure to check back on the stocks dividend over time. Often if the divdend is TOO high (for the purpose of this article, we will say 10% and above, that the company is just trying to find dividend investors (which would ultimately lead to a drop in stock price). A company showing solid dividend growth over several years and a dividend of 3%-6% would be ideal. Similar to Value Sign #3 (P/E Ratios), an investor will often find that most bluechip, utility, and other mature companies will pay dividends. This is because they are actually making money... I realize this may sound very obvious, but this is a good thing for a stock to do. If you own your own company, would you rather have the potential to make money, or actually be making money. As I mentioned earlier, lots of investors are enticed by the chance to own "the next big stock", but more often than not, the hype is eventually overcome by reality (and subsequently, the stock price will drop over time... ie: the dot-com bust). So, finding a stock that has proven that it can make money, and more importantly is willing to share that money with investors is something to be excited about. It is also always a good idea to reinvest these dividends for future growth (compounding interest is a long-term investors best friend). Solid dividend growth, when coupled with the previous two value signs, is the first step to finding a worthwhile stock. So, do your homework and go pick some long-term winners!

value signs of stocks

additional reading on value investing

3 more value signs...

Follow this link to read my next article where you will learn more about book value, debt-equity ratio and return on equity


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