Value Strategy: 3 Steps to Identify Quality Stocks

Many investors just look at the price of a stock.

But the market is just what you pay for.

The value is what you get.

For a company whose market value has risen sharply in the past, many consider it expensive, a stock that has fallen for a bargain.

The question must always be: What do I get value for the price?

What is the intrinsic or true value of a company and what price is paid on the stock market for the company? This difference is of great importance to value investors.

Even top companies sometimes have problems.

The stock market then tends to “punish” these companies disproportionately.

These situations have often been very good buying opportunities in the past, because top companies usually overcome their problems and emerge stronger from crises.

It also happens that companies improve their earnings and earnings year after year, but the market ignores the ever-improving starting position.

The stock is thus always cheaper at unchanged price relative to their value.

What do you have to do if you want to trade in the value principles of Buffett, Graham? You need to know what quality means in a company and how you can specifically determine that.

Only then do you make a statement about the fair enterprise value. You can do this in three steps.

Step 1: General Business Review

With the following general business assessment questions, you can quickly identify classic value companies.

  • Is the company easy to understand, does it have a consistent history?
  • Are the products urgently needed, is there no direct replacement?
  • Are there few restrictions so that the company can simply expand? Is the production simply expandable?
  • Are the products clearly distinguishable from the competition products?
  • Does the company have a monopoly position?
  • Does the company still have growth potential? Will demand still grow enough?
  • Does the company have extensive freedom in pricing?

You will not find many companies where you can answer all these questions with a clear “yes”.

Most of the time, these are already very familiar companies.

Put yourself back in the past for 10 years and think about what you would have answered if asked, “Which are the 10 best companies in the world?

Without having any business knowledge, let alone ever reading a balance sheet, you would come to companies like Coca-Cola, Microsoft, or Walt Disney alone with all your common sense.

You will automatically come across strong brands.

For example Beiersdorf with the personal care product and Nivea, Heinz Ketchup, Johnson & Johnson with the Penaten cream, Procter & Gamble with the Pampers diapers, Nestlé with a smorgasbord of world-famous brands, Unilever with Knorr and other brands or L’Oréal with the well-known cosmetics.

Step 2: Measurable quality criteria

In this step, you specifically control measurable company key figures. These allow you to compare several stocks with each other. Quality criteria include:

  • Equity ratio over 30%: The percentage of equity in total assets is called the equity ratio. Pay attention to the highest possible equity ratio. It should be at least 30% if possible.
  • Return on equity (ROE) over 25%: The return on equity is the return on invested equity. Here you divide the annual profit by the equity. This tells you how the company’s equity capital bears interest. The return on equity should be 25% or more.
  • Profit growth over 10%: Future profits determine the value of the stock. The profits of the company should grow steadily. Good companies can do that. The growth rate should exceed 10%.
  • Return on sales over 10%: The return on sales indicates how much of each dollar of revenue remains in the company as a profit. The higher it is, the stronger the market position of the company and the sooner cost increases or price reductions can be absorbed. The return on sales should be at least 10% and grow over the years.
  • Cash flow margin over 15%: Cash flow refers to the receipt of cash from the sales process and other sources within a certain period of time. The cash flow analysis provides you with information about the financial strength of a company. The cash flow margin indicates how much (in percentage terms) the company generates from its sales.
  • Capital investment below 40%: For example, companies with high capital expenditures need to invest a large part of their profits in machinery just to keep the business running. In inflationary times, these companies are hit even harder. In order to ensure sufficient profit for further growth, the share of capital expenditures should not exceed 40% of the cash flow.

Step 3: Determine the true value of the company

In the previous sections, you learned how to identify quality in your organization. You are now able to filter out the best from a variety of public companies at any time.

But that’s not enough – you should pay as little as possible for this high quality.

For this reason, the true inner enterprise value must be determined and derived from how much a company will bring in the next few years as a return.

This requires an estimate of the future true enterprise value.

Only extremely stable companies are easy to plan.

For example, a company that has been able to increase its profits by 15% per year over the last 10 or 15 years, in all likelihood, is likely to continue to grow faster than a company that has developed very unevenly in the past.