How to Buy Stocks | Investment Strategy 101
Without professional training, 95% of amateur investors buy shares at the wrong time and in the wrong companies. Most buy shares in good companies … they just pay too much to get in on the action.
First-time traders buy overvalued stocks. Even as their companies make increasing profits, they lose money.
That’s because most first-time investors buy “hot” companies. If you are going to buy a company’s stock because …
- An analyst has recommended it
- Everyone you know loves the company’s products or services
- Its price has increased a lot in the past
… you are about to buy a hot company.
Traders need to find inexpensive and strong companies companies who’s stock price will climb over the years. This guide teaches you how to do it.
Buy Strong Companies at Good Prices
Value investing is a trading philosophy of buying strong companies at reasonable prices and sticking with them for the long run. If you are new to trading, this is the only style of investing you should attempt.
Over the next few weeks, we will be teaching you the basics of value investing. You do not have to pay a dime for this service. Just bookmark us and stay tuned.
Long Term Outlook
We will be evaluating companies on a 4 year plus time horizon. This is not only a sound investing practice, it puts us a step ahead of thousands of trigger-happy day traders. While most investors focus on quarterly earnings reports and today’s rumors, we will be seeking out companies with good long-term value.
Using a 4 year plus time horizon applies to every aspect of our stock evaluation process. While most people are sweating the details, we see the big picture. When there is a specific area for concern, only then do we pull out the microscope.
Starting to see how our way of thinking puts us ahead of the competition?
Comparing Apples to Oranges
Apple is trading for $220 dollars. Dell is trading for $13. Which is a better deal?
You need a measurement that will allow you to begin to compare the value of two companies. This unit should measure what we are most interested in: profitability. To put all companies on an equal scale, you must divide how much each company makes (per share) by how expensive their stock is. This is called the Price to Earnings ratio. The higher the ratio, the more expensive the company is relative to its profitability.
PE = (1 year Net Income Per Share) / (Current Stock Price)
Since we like to look at companies over a longer time period, we will calculate a second measurement, the 4 year PE ratio.
4yPE = (average Net Income during past 4 years) / (Current Stock Price)
Using Google Finance, we look up the company: Republic Airways Holdings (Public, NASDAQ:RJET). Next, we click the “Financials” link to see the company’s Income Statement. The default view looks at quarterly data, so we change that to yearly. At the bottom of the yearly view of the Income Statement we see this data:
To better serve as a teaching example, let’s assume RJET made a small profit in 2009. Say $0.05 per share.
Now, calculate the 1 year and 4 year Price to Earnings Ratio based upon the current stock’s price of $5.
1yPE = 5/.05 = 100
A PE of 100 would make this company look outrageously expensive to most investors and they would pass it over. As long term investors, we would like to see the larger picture.
4yPE = 5/[(.05+2.53+2.02+1.79)/4] = 3.13
To help put this number in perspective, I have calculated the 1yPE and 4yPE for Southwest Airlines based on it’s current price of $13.
Southwest 1yPE = 100
Southwest 4yPE = 28.6
Looking only at 1yPE, both of these companies look outrageously overpriced. But when we look at the 4yPE, we see that Republic Airways (RJET) could be a great buy. Now we have to learn a little more about the company .
Get the Big Picture
First, let’s look at RJET’s stock price history over the past 5 years to start piecing together the story behind this company.
The company’s stock took a dive during the middle of 2008. Let’s keep that in mind, and see what happened to the company’s revenue during that time period–maybe they lost a lot of customers?
Just the opposite. This graph shows that the company actually increased their customers, but profitability decreased. We need to know why. So, let’s see how the business changed in overall size.
In 2008 and 2009, the business expanded rapidly, as shown by the increase in Total Assets on the graph above. To finance the expansion, the company borrowed money, as shown by the increase in Total Debt.
What other high level information can we add to the picture? Common knowledge tells us that at the same time the stock price dropped:
- Fuel prices were soaring
- The Great Recession hit
Now, let’s put all this information together to create the story of this company:
“RJET was expanding at the same time a economic crisis was brewing. To make matters worse, fuel prices were increasing. In order to grow, RJET took out loans. With these loans came increasing costs to cover interest payments. RJET’s expansion did result in more customers, but not enough to offset increasing interest payments and fuel prices. The economic collapse of the Great Recession likely decreased airline demand, but the lost revenue was not apparent in the data due to the company’s expansion. Making a bold statement about their business outlook, company management continued expanding even during the economic crisis.”
Knowing this, would you:
a) Highlight this promising company for further research
b) Cross this company off your list
Score high enough answering these questions, and life would be pretty sweet.
Tell the story of company after company and your level of insight, speed, and accuracy will improve dramatically. This is one test worth studying for.
If you would like to learn our full stock evaluation process fill out the form below and receive info on our Stock Evaluation 2.0 Video Course.
