Quick Take: A cheap stock can be an expensive mistake

By Larissa Fernand |  06-10-22 | 
 

A big mistake investors make is to buy a poor quality stock simply because the price is low. This is because they conflate a low-priced stock with low risk. Ironically, what might seem cheap may be extremely risky.

Highs and Lows are meaningless without a reference point. That is why you need to compare the market value (current price) with its fair value.

Fair Value Estimate, or FVE

This helps you determine whether the price of a stock is high or low compared with its fundamental value. The calculation involves looking at a company’s financial statements and annual reports, and assessing the management structure, competitive advantage, and corporate governance. It estimates the future cash flows of the company and adjusts them to today’s value. Based on that research, a guideline is provided that estimates the value of the company and what one share of stock is worth.

Fundamental analysis is not perfect. It is an estimate, and there are uncertainties involved for sure, but it is a much more reasonable estimate of the long-term fair value of a stock than just “buy the dip”.

Economic Moat

Also consider the moat of the stock when investing for the long term. The moat is a good indication that the company can sustain future earnings and fend off competition. If businesses don't have a competitive advantage, that means they are susceptible to competition or the vagaries of the market cycle. Their earnings are much more likely to go away without a moat.

A company whose competitive advantages Morningstar expects to last more than 20 years has a wide moat; one that can fend off their rivals for 10 years has a narrow moat; while a firm with either no advantage or one that we think will quickly dissipate has no moat.

Further Reading

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