In the book, The Intelligent Investor, Benjamin Graham offers a very simple method for choosing individual stocks. His idea is called "value investing," because he believes that the only way to make money in the stock market is to find companies whose prices are low compared to their actual worth.
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Graham's philosophy is based on the principle that the price of a company reflects its cash flow or the money it generates after paying all expenses. He defines a company's worth as the sum of its assets minus its liabilities. When a business has more assets than liabilities, Graham says, it's underpriced and therefore has the potential to generate high returns over time.
To determine a company's true worth, Graham looks at several factors. First, he examines the company itself. Does it have a good reputation? Is it growing rapidly? Do its products sell well? How much is it earning now, and what will it earn next year, two years, and ten years from now? What is its debt ratio? And most important, how does the company compare to its competitors?
Next, Graham examines the industry in which the company operates. He looks at the general economic climate and asks himself: Will this company continue to grow in the future? Are there strong growth rates in other industries that could affect its prospects? Has the company made acquisitions that might cause it to be hurt by economic changes?
Finally, Graham considers the company's past performance. He reviews its earnings history, compares it to its peers, and determines whether it has earned a good profit. He also analyzes the company's management team and its record of successful mergers and acquisitions. And he monitors the stock market's reaction to a company's actions, looking for signs that the market expects a profit down the road.
Graham concludes that the best way to determine a company's value is to examine it as an owner would, rather than as a banker or a speculator. By doing so, he believes, you'll find undervalued companies and earn superior profits.
The problem with Graham's theory is that it requires a lot of work. He recommends that you spend several hours each week studying the financial statements of potential stocks. While it's certainly possible to do this, many people simply aren't equipped to analyze a company's financial statements. So, instead of buying individual stocks, they choose to invest in mutual funds.
One advantage of putting your money in a fund is that you don't have to do anything except decide how much you want to invest. Then you can sit back and watch your money grow. A mutual fund allows you to diversify your portfolio without having to research every single stock individually.
Another thing is that most people have trouble sticking with a fund long enough to reap the full rewards of Graham's strategy. They jump in and out too frequently. As a result, they may make only mediocre gains.
So, if you're interested in investing in individual stocks and are willing to do a little homework, consider purchasing Benjamin Graham's classic book, The Intelligent Investor. It will be a worthy read.
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