Legendary investor Warren Buffett is best known for identifying which stocks are undervalued or selling for less than what they’re actually worth.
But how does he identify which stocks are undervalued? And how can you do the same? Here’s what you need to know about undervalued stocks.
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Intrinsic Value
To find stocks that are selling for less than they are worth, you first have to determine how much they are actually worth. Buffett referred to this as intrinsic value.
“If we could see, looking at any business, what its future cash inflows or outflows from the business or from the owners would be over the next, we’ll call it a hundred years or until the business is extinct and then could discount that back, at the appropriate interest rate, that would give us a number for intrinsic value,” said Buffett at a 1997 Berkshire Hathaway shareholder meeting.
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Margin of Safety
Once Buffett estimates a company’s intrinsic value, he discounts that by 30% or so to come up with the price he’s willing to pay. This margin of safety minimizes his risk.
Competitive Advantage
Predicting future cash flow involves some crystal-ball predictions. But figuring out what a business’ cash flow will be in 10 or 20 years includes more than just looking at what it’s made so far. Buffett also looks at the company’s competitors to make sure that his target company has an advantage that cannot easily be replicated. He wants to be sure that the companies he buys will continue to be a top choice for consumers.
Circle of Competence
Buffett only invests in businesses that operate in industries that he understands. For years, Buffett avoided tech stocks because he said he didn’t understand what the companies did. Understanding the business that his target companies are in helps him to evaluate them more objectively.
Applying Buffett’s Methodology to Your Investments
When looking at your own portfolio, you can apply Buffett’s strategy to your purchase decisions. Identifying intrinsic value may be the most complicated part, but help is available. Take a look at analysts’ expectations for the next 12 months and review the company’s recent earnings calls for the longer-term outlook. And be sure to consider the circle of competence. Do you understand how the business makes money and do you think they provide a good product or service?
Applying Buffett’s strategy to your own investments doesn’t mean every stock you’ll pick will be a winner. But by mimicking his disciplined approach, you may find you’re doing better than most.
Editor’s note: This article is for informational purposes only and does not constitute financial advice. Investing involves risk, including the possible loss of principal. Always consider your individual circumstances and consult with a qualified financial advisor before making investment decisions.
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This article originally appeared on GOBankingRates.com: Warren Buffett’s Secret To Finding Undervalued Stocks — and Making Them Work for You
