The critical questions in value investing are:
- At what rate will earnings (and dividends) grow over the investment period?
- What is the risk? How reliable are earnings?
- Can management be trusted to perform?
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None of these factors can be answered with certainty, we have to make our best estimate after considering a number of factors.
- Do historic earnings (per share) show a strong upward trend?
- Do historic sales (per share) show a strong upward trend?
- Has management consistently achieved a high Return on Equity?
- Is the return from new investments high enough to justify expansion?
Free Cash Flow
How much capital is needed to fund future growth?
- Where will this capital come from?
- Out of retained earnings?
- Out of new stock issues?
- Through increased debt?
Are retained earnings available to fund growth?
- Are depreciation provisions adequate to fund the replacement of existing assets?
- Is new capital expenditure required just to retain existing business or is it available for new investment?
- Is the business a cash cow? Or is new growth dependent on large capital expenditures?
- Is growth dependent on large acquisitions? What is the company's track record with acquisitions?
- Is the company likely to experience changes in its effective tax rate? Will it pay a higher rate of tax in the future?
- Have dividends been maintained and regularly increased?
- Does the company receive regular income from repeat business or does it continually have to find new customers for its products and services?
- Are the products consumable, quickly used up and reordered, or does the company sell durables that will not be replaced for a number of years?
- Does the company provide a repeat service to business or private customers? How regular are the service payments?
- Is the growth of the company dependent on it expanding away from its home
base into new markets?
- Has it proved that it has the capability to expand into new markets?
- New cities?
- New states?
- International markets?
- Does it have high brand awareness in the new markets?
Profit margins are dependent on the company's ability to withstand competition from existing and new competitors. Any evidence of product discounting or price wars should set the alarm bells ringing.
This is Warren Buffett's favorite. He looks for companies that have a sustainable competitive advantage:
- Does the company have a consumer monopoly?
- Does the company own strong brands that can withstand competition? Are retailers obliged to carry these brands?
- How reliant are customers on the product or service?
- Does the company have special skills or knowledge that are difficult for competitors to acquire?
- Is the company's knowledge protected by patents or copyright?
- Does the company own a distribution channel that is difficult for competitors to replicate?
- Can the company raise prices in line with inflation?
- Is there a threat from new competitors?
- Is there a threat from new technology?
- Is the company maintaining its competitive position?
- Is there sufficient spending on research and development?
- Is research and development producing results?
- New products?
- New patents?
- Is there a threat from alternative distribution channels?
- Is there a threat from substitute products?
- Are there indirect competitors? Other industries that may fill the same need?
- Is the company overly reliant on a single product?
- Is the company overly reliant on a single customer?
- Is the company overly reliant on a single supplier?
- Is the company overly reliant on a single individual?
- Is the company overly reliant on debt funding?
- Will the company be affected by any political changes?
- New taxes or subsidies?
- Monopoly legislation?
- Increased regulation or consumer protection?
- Environmental legislation?
- Labor regulation?
- Duties on imports?
- How are the companies relations with its employees?
- How responsible are management in dealing with shareholders funds? Are decisions always made in the interests of shareholders?
- What is management's track record with new projects or acquisitions?
- Do management involve shareholders in the business or do they work on a "need to know" basis?
- Does a major shareholder have another agenda? Are they trying to create a family dynasty?
- Do management involve employees in the business?
- Is there adequate profit participation and share incentives?
- Is there a climate of management excellence?
- Do management have proven industry experience?
- How have management fared with new ventures? Do they know their own limitations or have they strayed far from their industry base?
- Are there strong financial controls?
- Is management cost-conscious or extravagant? A company that announces cost cuts after a poor performance has often taken its eye off costs during the good years.