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Many investors believe that finding promising stocks is the hardest part of investing. In reality, though, discovering the stocks that deserve further research is just the tip of the iceberg -- and the most important part of making a smart investment is something many people never even bother doing.
A needle in a haystack
There's no shortage of promising stocks, especially if you aren't wedded to a particular investing method. If you're a value investor who focuses on finding bargain-basement stocks that others have left for dead, then you'll find completely different prospects than a growth investor who prefers young companies with their brightest days still ahead of them. If you're an international investor who prefers scouring the world for the top players in the global economy, then you'll get a wider range of potential investments than someone who only looks at companies in their home country.
But regardless of what stocks you gravitate to, there's one thing you should always know before you make an investment: what you believe the stock is worth. That single number will not only guide your initial decision to buy a stock but also provide a foundation well into the future as you revisit whether to hold or sell it.
Being smart about valuation
The thing that many beginning investors forget about investing in stocks is that every stock has two equally important attributes: its financial prospects and its current share price. Too often, investors focus on one or the other but not both -- and each mistake has its own disastrous consequences.
On one hand, plenty of companies have such rosy financial prospects that they seem to justify any price. For instance, as energy prices headed toward their climax in mid-2008, energy-related companies like Chesapeake Energy (NYSE: CHK ) and ConocoPhillips (NYSE: COP ) reached amazing heights. Their prospects seemed limitless, as a high-price environment not only increased the value of their proven reserves but also made it more economical to explore new untapped resources.
Yet as herd-following investors poured into those stocks, their skyrocketing shares failed to take into account the possibility of lower energy prices in the future -- and the ensuing bust took those shares down sharply. Other commodity-related stocks, such as PotashCorp (NYSE: POT ) and Southern Copper (NYSE: PCU ) , suffered the same fate.
What goes down need not go up
On the other hand, paying attention to stock price without considering the underlying business can also lead to mistakes. Every hot stock, from Crocs (Nasdaq: CROX ) to Krispy Kreme to Enron, reaches a point at which its shares have fallen 50% or more from their peaks. At that point, value investors often rush in, exclaiming about how such a huge discount from those peaks must automatically represent good value.
Sometimes, those gutsy investors are rewarded, as we've seen over the past year with stocks like Ford Motor (NYSE: F ) and Starbucks (Nasdaq: SBUX ) . But you can't count on this strategy to work 100% of the time. A lousy business at half the price is still a lousy business -- and if it can't generate the results to sustain even a half-sized stock price, then you can bet the shares will just keep falling.
Have a guide
That's why having a sense of a stock's intrinsic value is so important. By comparing a stock's current market price to your own assessment of its value, you get a useful read on whether you have a margin of safety in making an investment. That sounds like a value-investing perspective, but it applies just as well to growth-oriented stocks.
The challenge, of course, is how you assess intrinsic value. Unfortunately, you'll find that no one tool works in every situation. For example, P/E ratios might work well for mature slow-growth companies but give false impressions of fast-growing innovators. Discounted cash flow analysis lets you include more information about future prospects but is also more dependent on assumptions that may prove inaccurate. All told, using a combination of methods to assess intrinsic value is probably best in every situation.
The benefit of that work, though, is that knowing the value of a stock makes investing decisions easy. Going forward, as you modify your value estimate based on changing conditions, you can compare it against the stock price's own movements in the market. Knowing your value will help you filter out all the noise in the market price, helping you build confidence in your positions and helping prevent trading on emotion.
So before you invest, always know what you think a stock is worth. You won't always be right -- but just going through the exercise will help you avoid many more costly mistakes.
You can still find bargains even after the market's rally. Ilan Moscovitz can show you the market's cheapest stock.