The share price graph is one of the most used tools in company analysis. Whether consciously or sub-consciously it undoubtedly always plays a part. Ask yourself if you’ve ever thought or heard someone use these phrases:
“The share price has rallied hard this month so we’ve missed out” or,
“The share price has doubled this year so it must be a good business”, or
“The share price has seen steady decline all year so I wouldn’t touch it with a 10 foot pole”.
It’s easy to find good listed businesses; the ASX is full of them. The challenge is buying them at the right time. And I’m not talking about trying to time the market – that is a fool’s game. But buying these excellent companies when their valuation is favourable is the key to good investing.
There are two main methods we use at Farnam to value a business: by building a discounted cash flow (DCF) and using a price to earnings (PE) multiple. A detailed explanation of each is beyond the scope of this article, but briefly, a DCF values the business based on future expected earnings discounted to the net present value, and the PE takes the current multiple the stock trades on and compares it to a group of industry peers.
As a beginning investor, it may seem daunting as you start to build a portfolio. You have some money that you want to invest but you don’t want to put all your eggs in one basket. So you decide to find a handful of companies and diversify.
Good companies are everywhere. Some you will see in the world daily – like Dominoes or the Banks. But many good companies can go unnoticed by those who are not looking. Equally, just because a company is large and well-known, does not automatically qualify them for an investment.