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5 Terms You Must Know When Analysing Stocks

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5 Terms You Must Know When Analysing Stocks

The following terms will help you understand what renowned investors mean when they use such terminology.

1) Intrinsic value

This is the actual value of a stock as opposed to its current market price. The intrinsic value is arrived at taking into account current cash flows, estimated future cash flow, growth potential, and competitive positioning that accounts for variables such as brand, trademarks, patents and copyrights.

The discounted cash flow approach is most commonly used. This starts with the proposition that the value of the stock is not what someone perceives it to be worth but it is a function of the expected cash flows on that asset. So a company with high and predictable cash flows should be assigned a higher value than one with low and volatile cash flows. In discounted cash flow valuation, the analyst will estimate the value of the stock as the present value of the expected cash flows on it, discounted back at a rate that reflects the riskiness of these cash flows.

2) Margin of safety

If you had asked Benjamin Graham (the father of value investing) to distill the secret of sound investing into three words, he might have replied, "margin of safety." Those are still the right three words and will remain so for as long as humans are unable to accurately predict the future.

As Graham repeatedly warned, any estimate of intrinsic value is based on numerous assumptions about the future, which are unlikely to be completely accurate. By allowing yourself a margin of safety--paying only Rs 60 for a stock you think is worth Rs 80, for example--you provide for errors in your forecasts and unforeseeable events that may alter the business landscape. By purchasing the stock at Rs 60, it allows you to be wrong by 25% but still achieve a satisfactory result. The Rs 20 difference between estimated fair value and purchase price is what Graham called the margin of safety. Warren Buffett considers this margin-of-safety principle to be the cornerstone of investment success.

Also read: 5 investing lessons from Warren Buffett

Just think, if you were asked to build a bridge over which 10,000-pound trucks were to pass, would you build it to hold exactly 10,000 pounds? Of course not--you'd build the bridge to hold 15,000 or 20,000 pounds. That is your margin of safety.

What this means is that instead of buying a stock based on what everyone else is doing, buy a stock only when it's selling at a decent margin of safety to your estimate of its fair value (intrinsic value). Don't even think about the overall direction of the stock market, because that's impossible to predict with any consistency. By doing this, you'll need to exercise a lot of discipline and wrestle with the fear of missing out on a market rally. Patience is indeed a virtue when using this approach because oftentimes it may take many months, or longer, before an opportunity presents itself.

3) Moat

A moat is a deep and broad ditch filled with water that acts as a preliminary line of defence to a castle or a town. In other words, it keeps invaders out. Using that very analogy, Warren Buffett coined and popularised the term economic moat, which refers to a barrier that protects a company from competition.

Let's say a firm is doing very well and generating high profits. Naturally, this would result in competition because capital flows to the areas of highest potential return. High profits attracts competition and competition reduces profitability. The firms that stay profitable for a long time manage to do so by creating economic moats.

An economic moat is a structural business characteristic that allows a firm to generate high returns on capital for an extended period. It acts as a barrier that protects a company from competition.

Also read: 5 sources of economic moats

4) Moat trend

Economic moats aren't stagnant over time. Rather, competitive dynamics are constantly shifting as technology develops, regulations change, competitors exit or enter a market, companies gain scale, and so on. This is where our moat trend ratings come in.

If the underlying sources (or potential sources) of a company's competitive advantage are improving over time, the company has a positive moat trend.

If the underlying sources (or potential sources) of an economic moat are weakening or a company faces a substantial competitive threat that is growing, then it has a negative moat trend

For example, the switching costs and network effects that historically benefited Microsoft's Windows operating system are being steadily eroded by the growth in smartphones and tablets, where Google's Android and Apple's iOS dominate.

5) Circle of competence

If Buffett cannot understand a company's business, then it lies beyond his circle of competence, and he won't attempt to value it. He famously avoided technology stocks in the late 1990s in part because he had no expertise in technology. On the other hand, Buffett continued to buy and hold what he knew. For instance, he was willing to purchase a large stake in Coca-Cola because he understood the company's products and its business model.

Although it might seem obvious that investors should stick to what they know, the temptation to step outside one's circle of competence can be strong. During the technology stock mania of 1999, Berkshire's return badly trailed the market's return, and a number of observers commented that Buffett was hopelessly behind the times for eschewing technology stocks. However, Buffett has written that he isn't bothered when he misses out on big returns in areas he doesn't understand, because investors can do very well (as he has) by simply avoiding big mistakes. He believes that what counts most for investors is not so much what they know but how realistically they can define what they don't know.

Charlie Munger believes that investors who get outside their circle of competence can easily find themselves in big trouble. Within it, a given investor has expertise and knowledge that gives him or her significant advantage over the market in evaluating an investment. Munger pointed out that even one of the world's greatest investors stepped outside of his circle of competence during the tech bubble: "Soros couldn't bear to see others make money in the technology sector without him, and he got killed."

Also read: 5 investing lessons from Charlie Munger

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

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