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How to Invest in the S&P 500? All you need to know to invest in the index

The S&P 500, which stands for Standard and Poor’s, is a stock market index that monitors the 500 largest publicly traded U.S. companies. The companies in the index are added on the basis of their market capitalization. So the bigger the company, the more influence it has over the index.

A corporation must be a large-cap company with a market cap of at least $8.2 billion to be included in the Index.

The S&P 500 is one of the most followed market indexes in the world. When you hear people talking about the market going up or down, they’re probably referring to the S&P 500.

Understanding S&P 500 Index in Stock Market

Given the popularity of the S&P 500, it’s no surprise that S&P 500 index funds are among the most popular investments out there. These index funds are based on the S&P 500 which has returned around 10% annually over the past 90 years.

How to Buy an S&P 500 Index Fund?

Purchasing an S&P 500 fund is surprisingly simple. Here are the steps;

1. Find your S&P 500 ETF or Index Fund

First, you need to find an index fund or ETF that is based on the S&P 500.

All the index funds and ETFs that are based on the S&P 500 will have the same companies and same weightings.

That makes the selection process a lot easier.

Imagine, if you are told to decide between five McDonald’s restaurants that all serve the same food: Which one would you choose? You’d probably choose the cheapest eatery, and index funds are usually no different.

And here is something to consider while choosing an index fund:

Expense Ratio

You should look at a fund’s expense ratio to see if it is reasonably priced. This is the fee the fund manager will charge you for managing the fund throughout the year.

A fund, for example, might charge 0.30 percent. That implies for every $10,000 you put in the fund; you’ll pay $30 per year.

If you’re buying mutual funds, check to determine if the fund management charges a sales load, which is a fancy term for a sales commission. This is a fee you should avoid at all costs, as it can eat up your long-term returns.

The expense ratios of S&P 500 index funds are among the lowest on the market.

Even if you don’t choose the cheapest fund, index investing is already less expensive than practically any other type of investment. Many S&P 500 index funds have yearly fees of around 0.02%.

2. Create an account with a brokerage firm.

To invest in the S&P 500, you’ll need a brokerage account. This can be an IRA, a company-sponsored 401(k) or equivalent account, or your own traditional, taxable brokerage account.

E-Trade, Fidelity, Charles Schwab, and TD Ameritrade are some of the popular brokerages where you can open an account.

3. Calculate how much money you have available to invest.

You don’t need to be affluent to start investing, but you do need a strategy. And figuring out how much you can invest is the first step in that plan.

You should deposit money into the account regularly and expect to keep it there for as long as you can. The less money you have to invest, the more crucial it is to choose a broker with cheap costs.

4. Pick Your Favorite S&P 500 Fund

Once you’ve decided between ETFs and index funds, you can compare more precise details to determine which fund is best for you. To begin, consider any costs and fees. When you can receive roughly the same thing from numerous sources, you don’t want to overpay.

The following are the fees for some of the most prominent index funds:

  • – With a $100 minimum, Schwab charges 0.02 percent for the Schwab S&P 500 Index Fund (SWPPX).
  • – Fidelity’s Spartan S&P 500 Index Investor Class shares (FXAIX) have a low fee of just 0.015 percent and no minimum investment.
  • – The Vanguard 500 Index Fund (VFINX) has a $3,000 minimum investment and a 0.14 percent fee.
  • – The SPDR S&P 500 ETF Trust (SPY) has an expense ratio of 0.09% and no minimum investment.
  • – Vanguard S&P 500 ETF (VOO) has an expense ratio of 0.03%, and you need to purchase at least one share of the fund. Currently, the fund trades at $421 a share
  • – Vanguard S&P 500 UCITS ETF (VUSA.L) is an S&P 500 ETF that is available for investors in Europe. The fund has an expense ratio of 0.07% and a minimum investment of $500.

5. You’re the proud owner of an index fund!

That’s all there is to it. The procedure of opening and funding a brokerage account is straightforward. You can invest in an S&P 500 index fund in just a few clicks after the funds have cleared.

It’s a wonderful first investment and a fun way to get your feet wet in the stock market.

Benefits of Investing in S&P 500

S&P 500 index funds have grown extremely popular among investors for many reasons.

Invest in a lot of stocks:

Even you own one share of the index fund, your investment would be spread across the 500 companies in the index.

Diversification:

Since you’re investing in a diverse group of companies, you’re reducing your risk. When you own a lot of companies, a bad performance by one of them won’t affect you as much.

Low Price:

Since index funds are passively managed rather than actively managed, they have low expense ratios. As a result, more of your hard-earned money is invested rather than paid as fees to fund managers.

Exceptional Results:

Your returns will match the performance of the S&P 500, which has traditionally averaged around 10% annually over the past 90 years.

Simple to Purchase:

Investing in index funds is easy as it takes less time and requires no investing knowledge.

These are the main reasons why so many investors have flocked to the S& P 500.

Which companies are in the S&P 500 index?

The S&P 500 index consists of 505 stocks from 500 distinct companies. The difference in the numbers is because a few S&P 500 companies issue various classes of shares. The index, for example, includes Alphabet Class C (NASDAQ: GOOG) and Alphabet Class A (NASDAQ: GOOGL) shares.

Listing all of the S&P 500 companies would be impractical. However, because the S&P 500 is weighted by market capitalization, its performance is mostly determined by the performance of the largest companies.

With that in mind, here’s a look at the S&P 500’s top ten firms as of March 2021. This list and its order may, and most likely will change in the future.

·       Microsoft (NASDAQ: MSFT)

·       Apple (NASDAQ: AAPL)

·       Alphabet Class A (NASDAQ: GOOGL)

·       Alphabet Class C (NASDAQ: GOOG)

·       Berkshire Hathaway Class B (NYSE: BRK.B)

·       Tesla (NASDAQ: TSLA)

·       Amazon (NASDAQ: AMZN)

·       Facebook (NASDAQ: FB)

·       JPMorgan Chase (NYSE: JPM)

·       Johnson & Johnson (NYSE: JNJ)

Why should you invest in the S&P 500?

Warren Buffett, the legendary stock market investor, famously stated that a low-cost S&P 500 index fund is the best investment most people can make.

It’s easy to understand why.

The S&P 500 has provided annualized total returns of 9% to 10% over the past 90 years.

Investing in the S&P 500 allows you to gain broad exposure to the profitability of the largest companies without being overly exposed to a particular company’s performance.

With little work on your part, the S&P 500 can provide excellent returns for your portfolio over time.

Bottomline

Investing in an S&P 500 index fund might be a smart move for your portfolio.

Even if you only have a basic knowledge of how to invest, finding a low-cost fund is rather simple. Then, you’ll be able to enjoy the S&P 500’s consistent performance throughout time.

Key Takeaways

– The S&P 500 Index is a broad-based index of significant companies traded on US stock exchanges.

– With minimum due diligence, an S&P 500 Index fund can help your portfolio obtain wide exposure to certain types of stocks.

– Funds that mirror the S&P 500 index are often fairly low-cost, with a variety of selections to pick from.

– Over lengthy periods, the index often outperforms actively managed portfolios

Dip buying; The truth about the buying the dip.

“Time in the market beats timing the market”

Most investors believe that the best time to buy stocks is during a downturn or a ‘dip’.

But the question is – is buying the dip a good long-term investment strategy?

The truth about ‘buy the dip’

First, let’s understand what it means to ‘buy the dip’.

A dip is a decline in stock prices, across the broad market. The price drop of individual stocks and the price drop of stocks in a specific sector are also referred to using ‘dip’.

A dip can be a decline of 5% or 50%. Buying the dip means buying stocks when the dip occurs. Stock prices plummet in a dip. So retail investors looking to ‘buy the dip’ purchase those stocks, whose prices have declined.

Investors do this with the belief that the stock’s price will rise soon back to its previous highs. That means, you get the stocks for a discount, and make money as soon as the stock price returns to its previous level.

Sounds like the perfect strategy, doesn’t it?

Before you answer that let’s look at how this strategy will play out in real life.

Buying the dip

Buying the dip perfectly aligns with the ‘buy low, sell high’ outlook. That’s one reason why a lot of people choose this strategy. But what they don’t realize is that market timing is nearly impossible. So it does not matter how experienced you are, you just can’t predict the ‘lows’ and ‘highs’ in the market.

Nevertheless, let’s see how buying the dip will play out in real life.

Suppose you have decided to buy stocks when the market dips at least 20% from its highs. The plan is to wait till the market declines 20%, and then load up all the stocks you’ve been waiting to buy.

But before that, here are some questions you’ll need to ask yourself.

How long does it take for the market to go down 20%?

Once you decide you’re going to invest only when the market goes down at least 20%, you’ll need to wait for that moment. And believe me, it’s going to take a long time before you witness a dip of that magnitude.

You see, price drops aren’t that common. Since 1965, there have been only 8 drawdowns of 20% or more in the United States, once every seven years on average. That means you’ll be sitting on the sidelines with piles of cash, waiting for the market to go down, while regular investors grow their money by consistently investing in the market.

And even when the market finally goes down and you jump in and buy stocks at a 20% discount, it won’t matter. Because while you were waiting for the dip, the market went up 80%. That means, even with a 20% discount, you’re buying stocks for a 60% premium.

Even when the market rebounds and returns to its highs, you’d only have made a profit of 20%, whereas long-term investors who had been in the market all this time, managed to grow their money by 80%.

What if the market keeps going down?

This is another question you need to ask yourself; what if the market keeps on going down even after you buy the dip? What will you do then?

No, this is not an unlikely scenario. It has happened in the past, and it’s likely to happen in the future.

Because it’s impossible to predict how low the market will go. So buying at the lowest point is not exactly possible. For all you know, a small dip might be a major market crash, and it might take quite some time for the market to recover. So if your idea is to make some quick profits by buying the dip, you’re most likely to end up losing your money.

How sure are you about the market bouncing back?

The whole point of buying the dip is the belief that the stocks will bounce back, and they will go even higher.

But you’re not buying the whole market, only individual stocks. So hoping your target stocks will bounce back along with the broad market, is not a sound investment strategy. If you don’t analyze the fundamentals of each stock you might end up holding stocks that might not go up in the near future. You need to look at factors like; how the dip/crash has affected the business, how the company plans to bounce back, are there any permanent damages, and more.

Consider the case of airlines after the pandemic. Airlines were one of the many industries that were hit by the pandemic. As countries went into lockdowns, travel came to a halt. And most airline stocks tanked in March 2020.

Now, imagine your excitement seeing this dip. You see this as the perfect opportunity to pick up some good airline stocks for a discounted price. Because, why not? The stocks will be up, once the restrictions are lifted, and people start flying again.

But if you dig deep enough, you’ll find that the pandemic has changed a lot about airline industries and specifically, the part where people fly. You see, airlines made the most money from business travels, and that has been replaced by Zoom. Also, ask yourself, is this going to be the last pandemic we’re going to see in our lifetime?

The point is, blindly jumping at the opportunity to buy a stock at a discount is never a good idea. Especially if you are not sure what caused the dip in the first place.

What if you miss the best days in the market?

Another reason why waiting on the sidelines is a bad idea.

According to this data going back to 1930, Bank of America found that if an investor missed the S&P 500′s 10 best days in each decade, total returns would be just 91%, significantly below the 14,962% return for investors who held steady through the downturns.

There you have it. The final nail in the coffin.

We’ve already established that it’s impossible to time the market accurately. So the only way to make sure you don’t miss the best days in the market is to stay in the market. That means, not sitting on the sidelines, but actively investing in the market. That’s your best shot at making sure you don’t miss out on the massive gains from the 10 best days.

What if you can’t buy when the dip occurs?

Yet another aspect that investors overlook; the psychology of investing.

“Buy the dip is one of those things that works well on paper, but it doesn’t work well in real life”, says Callie Cox, senior investment strategist with Ally Invest. “It’s something that I struggle with because as an investor, I want to buy the dip, but I’m human and sometimes I don’t feel good when the market’s going down’’, said Cox.

This is the truth. It’s hard to buy more stocks when everyone is selling. Because we are humans, and we are wired to follow the crowd. The bandwagon effect explains this. It is a psychological bias that causes people to think or act a certain way if they believe that others are doing the same.

That’s the reason why most investors when they go through dips in the market, do nothing. While many would sell portions of their portfolio, only a few have the stomach to buy more shares.

What to do instead?

The wise alternative would be to stay invested in the stock market. Only then you’ll be able to fully reap the benefits of compounding. You see, if you invest $10,000 in the market earning 5% a year, in 20 years it would be worth $26,533. If you can manage to get that to 10% a year, the investment would be $67,275, in the same period.

That is the reason Albert Einstein described compounding as the ‘greatest mathematical discovery of all time’. And the more time you stay invested, the more valuable the investment will be.

Dollar-cost averaging

Dollar-cost averaging is one of the popular methods you can use to invest consistently. It is a strategy where the same amount of dollars are invested at a regular, predetermined interval. For example, $100 every month for the next 20 years.

This can help you maintain consistency in your investments and reap the benefits of long-term compounded gains. You can also dollar-cost average into index funds or exchange-traded fund (ETFs).

Bottomline

If you’re going to invest, do it consistently. Don’t wait on the sidelines waiting to buy dips. As a long-term investor, you’re likely to witness major and minor dips along the way. If you can see it as an opportunity and buy more shares of the stocks you own – good. If not, that’s okay, just make sure you don’t sell in panic.

Now, everything is obvious in hindsight. It’s easy to look back at March 2020, and regret not entering the market in March. Don’t be fooled by these thoughts.

Stay in the market. Buy stocks whenever you can, dip or no dip.

If you would like to know more strategies that can help in an adverse situation in the market, check out our guide on Bear Market Investing.

Safety margin; How to ensure returns from your stocks

“Value investing is trying to buy a dollar for fifty cents”

– Warren Buffett

The core principles of value investing revolve around the price at which an investor purchases securities. Because for value investors, what they buy is equally important as how much they buy it for.

That’s where the margin of safety comes in.

What is the margin of safety?

The margin of safety is a principle in value investing that encourages investors to buy stocks at a price significantly below their fair value. The term margin of safety was coined by Benjamin Graham, who is also known as the father of value investing. However, the term was popularized by his student and one of the most popular investors ever, Warren Buffett.

The margin of safety aims to reduce the downside risk of an investment, thereby increasing the chances of making a profit.

How does Margin of Safety work?

Calculating intrinsic value (also known as fair value) is the first step in determining the safety margin. It is calculated by taking various aspects of the underlying business into account; assets and earnings, management, industry outlook, etc.

Once you have the intrinsic value of a stock, you can set the margin of safety. The safety percentage varies from one investor to another, based on their risk tolerance. Some go for a margin of safety of 20%, meaning they set their target purchase price 20% below the stock’s intrinsic value. Meanwhile, some investors go for a higher margin of more than 50%.

Remember, it’s not 20% below its market price, but 20% below its intrinsic value. For example, suppose AMD trades at $100 a share, and as per your calculations, it has an intrinsic value of $80. So that means AMD is trading above its intrinsic value.

So an investor looking for a margin of safety of 20%, would set his/her target price at $64, 20% below its intrinsic value, $80. That means, the investor purchasing at $64 is likely to see an upside of more than 25%, as he has managed to buy the stock significantly lower than its market price.

However, it also means that the investor will need to wait for a while for the stock to come down to the discounted price of $64 from $100. At the same time, he also needs to make sure such a drop is not the result of deteriorating fundamentals.

Because often it could be due to a problem in the underlying business. If you go ahead and buy the discounted stock without re-analyzing the fundamentals you may end up in a value trap.

Using the Margin of safety

The margin of safety is incredibly useful in limiting downside risk. The margin of safety ignores the stock price. Instead, it looks at the intrinsic value of the stock and applies a discount on it, thus setting the target purchase price.

This highly increases your chance of making a profit from the stock. Take the case of AMD, for instance. AMD is currently trading at $100. If you can wait long enough to buy it at the price of $64, which is the target price as per margin of safety, you’ll enjoy a good profit from the stock.

At the same time, it also reduces the chance of incurring a loss. As you’re buying the stock for a price significantly below its market value, it’s unlikely that you’ll incur a loss.

Warren Buffet explains it perfectly; “When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing”.

Buffett is trying to say that you shouldn’t buy a stock that’s worth $100 for $90. You need to leave more room for human error in valuation, extreme volatility, or just bad luck in the market. So you buy it for $80 or $70, leaving sufficient room for error. And that’s how the margin of safety works.

Intrinsic value

To understand the margin of safety, let’s see how the intrinsic value of a stock is calculated. Some use discounted cash flow to calculate the intrinsic value, while some others take advantage of metrics such as Earning power value, absolute PE, or even the Graham formula.

But the truth is, intrinsic value is highly subjective. No matter how many variables you use, there’ll always be assumptions.

Hence, the margin of safety.

Because, what if the assumptions are wrong? How do you make sure that your assumptions don’t hurt your investment?

So you focus on the price you pay.

We make sure there is enough room to cushion any downfall, in the event our assumptions turn out to be wrong. So instead of trying to buy at its fair value, like regular investors, value investors apply a margin of safety of 20% – 30% and buy the stock.

Warren Buffett and Margin of safety

Even though Ben Graham coined the term, it was Buffett who popularized the concept.

The margin of safety perfectly aligns with the value investing philosophy Warren Buffett so profusely preaches. While value investing is aimed at finding undervalued stocks, the margin of safety acts as an additional cushion, to limit the downside.

The market price or share price has little or no significance when it comes to the margin of safety, It is calculated purely based on what it’s worth, that is intrinsic value. So even if the stock is currently trading below its intrinsic value, the margin of safety would still be applied to the intrinsic value.

Bottomline

The margin of safety is one of those concepts that most investors gladly ignore. Thanks to social media, investors these days only care about what’s hot – stocks and industries alike. But as a long-term investor, your objective is not to look for what’s hot. But look for stocks that can provide value to your portfolio. And that’s what value investing is all about.

And the margin of safety is will help you make sure you take care of the downside risk as well.

Happy investing!

And if you’d like to know the 20 stocks we think you can hold for the next 20 years, check out our bestselling book The 8-Step Beginner’s Guide to Value Investing.

What is a Moat and why is it important in investing?

What do Amazon, Apple, and Google have in common?

Apart from being some of the largest technology companies in the world, of course.

They all have what Warren Buffet referred to as economic moats.

Competitive advantage – Moat

A company’s economic moat is a long-term competitive advantage a company has over the competing firms. An economic moat can be thought of as an intangible asset – you can’t see it, but they’re key in the success of a company. An economic moat is a durable competitive advantage that sets the company apart from its peers.

Think about the wide and deep trenches surrounding the medieval castles. It protected the castle and the kingdom from enemies. That’s where the word moat originated from.

Just like the trenches, the economic moat helps the company to protect its market share and long-term profits from its competing firms.

Why are moats important?

Having an economic moat is key to the success of a company.

Take Coca-Cola (KO) for example. Their secret recipe is just one of their economic moats. And with that recipe, Coca-Cola sold its soft drinks in every part of the world. And none of their competitors could imitate Coca-Cola’s success, since they didn’t know the recipe.

There have been hundreds of soft drink manufacturers around the world since Coca-Cola first came out. But none has managed to overcome or even imitate Coca-Cola’s success.

Economic moats can help companies dominate a market, resulting in a consistent increase in long-term profits.

As an investor, investing in companies with multiple economic moats is a fail-proof way to generate maximum profits in the long run. As these companies maintain their market share, their earnings will continue to rise, so will the stock price.

How are economic moats created?

Economic moats are created when a company is able to distinguish itself from the rest of its competitors. This distinct advantage could be anything from pricing power to high switching costs.

Walmart is a great example of an older form of an economic moat. By economies of scale, Sam Wolton (Founder of Walmart), was able to grow Walmart into a retail giant, with 10,500 stores spread across 24 countries.

Economies of scale are defined as the ability of a company to sell its products at the lowest possible cost. Walmart achieved this early on in the business, thanks to its large number of stores. The key being Walmart’s ability to buy the merchandise in bulk, at significantly lower prices. As for suppliers, doing business with Walmart meant greater exposure to their products. Besides, Walmart was buying merchandise in huge quantities, which even with a discount, was profitable for the suppliers.

And this in turn allowed Walmart to sell the products at a lower price than their competitors. Thus an economic moat was achieved through economies of scale.

Types of competitive advantages

Walmart’s example shows an earlier type of economic moat. With the rise of technology, in the last decade, economic moats have been created by leveraging different aspects of a business.

Here are some of them.

Network effect

A company, product, or service has a network effect when an increase in the number of users increases the value of its services. The value increases proportionally with the number of users.

An earlier form of network effect can be found on telephones. When telephones were first introduced, only a few people owned them. So there weren’t many people you could talk to using a telephone. But once more people started using it, the value of the telephone increased, as now there were more people you could talk to. So more people started buying telephones.

The same goes for social networks.

Facebook, for example, grew using this network effect. As more people started using Facebook, the company got more data on how people used the platform. That helped Facebook in making improvements, which in turn drove more people to the platform. This flywheel is the reason why Facebook has 2.85 billion users.

A network effect is an example of a wide economic moat. If a company has a wide economic moat, it means that its competitors will have a hard time entering or competing in the market.

On the other hand, if a company has a narrow economic moat, it means that the competitive advantage may not be sustainable. Or a competitor might be able to overcome the moat. An example of a narrow economic moat would be the one created with patents that expire in a year or so.

Cost advantage

We’ve already seen how Walmart used the cost advantage to become the retail giant it is today. Similarly, companies create moats using various advantages related to cost.

Amazon, for example, created a moat for Amazon Web Services (AWS) both using economies of scale and high switching costs. We’ve already discussed economies of scale, so let’s see what switching costs are.

Switching cost is the cost that a customer incurs when switching from an existing service to a new one. Consider the example of banks. Sure, there are no fees to be paid for switching from one bank to another. But imagine the struggles of having to transfer your entire portfolio of assets. And don’t forget the paperwork. Often, the hassle is simply isn’t worth it. Thus, once a customer gets accustomed to a bank, he/she is unlikely to switch.

And the same goes for AWS. Once you get your website and other services running on AWS servers, it simply isn’t worth switching. Remember, we’re talking about large amounts of data here. Besides, AWS provides you with everything you need; machine learning, analytics, AR/VR, robotics. And the more services you use, the more difficult it is to transition to a different cloud provider.

This has helped AWS capture market share, and keep it. Even in 2021, they continue to dominate the cloud computing market with a share of 32% compared to 19% for Microsoft’s Azure and 7% for Google Cloud.

Brand value

Companies can use their brand value to create a moat. Brand value is nothing but the perceived value of the company by the public. This brand recognition allows the company to charge a premium, without losing market share. This can be achieved through some form of unique value proposition, messaging, and culture.

And if they can use the brand value to create customer loyalty, it’s an added benefit. In fact, brand loyalty can ensure dominant market share and consistent revenue.

Case in point, Apple Inc.

Just to illustrate the power of Apple’s loyal customers, here is a survey by SellCell. According to the survey, 91.9% of iPhone owners plan to buy another iPhone when they next upgrade, up 1.4% from 2019.

So how exactly did Apple achieve this level of loyalty?

For starters, Apple always had a strong and unique value proposition; creating personal experiences with the help of technology. They weren’t just making smartphones and computers, they were creating iPhones and Macs.

You might argue that they are just fancy names for an average product.

But when their customers want to buy a smartphone they don’t go like “I want this because it has 4 GB RAM, Quad-core processor, and 64 GB internal storage. Instead, they think; “I want this because it’s an iPhone.

Moreover, Apple created its brand around emotion. It got to the point where having an iPhone makes customers feel sophisticated. That’s the reason Apple continues to dominate the smartphone market even when there are better phones in the market, both in terms of technology and price.

This brand value allows Apple to charge a premium price, without losing market share to its competitors. Owing to that, iPhone sales contribute to half or more than half of Apple’s overall sales revenue, in recent years. It accounted for 48.6% of Apple’s total revenue in the third quarter of the company’s fiscal year 2021.

Intellectual property

While some companies build their brands through brand value and cost advantages others do so by leveraging internal resources, expertise, and legal protections.

These intangible assets are referred to as intellectual property.

Intellectual properties include patents, licenses, unique technology, etc. that are legally protected by intellectual property laws. This prevents competitors from replicating or using those properties. This allows companies to use these properties to create products or services, which can bring in a lot of revenue, as the competitors can’t replicate it.

Intellectual properties also include any form of copyrights and trademarks. For example, Disney has a lot of intellectual property in the form of all the animated characters it has created over the years. Mickey Mouse, one of the most popular characters in the Disney Universe, has been bringing in revenue from merchandise sales even years after the show ended.

Qualcomm is another example of a company that created a moat with intellectual property. The company has a massive patent portfolio with over 130,000 issued patents and patent applications around the world. They achieved this through huge and consistent investments in R&D over the years. The patents are mostly related to technology, such as 5G, wi-fi, Bluetooth, and mobile operating systems. This powerful moat has enabled them in achieving a 40% market share in baseband processors.

Qualcomm also licenses these technologies to other companies. And that has brought a huge source of revenue over the years. It is also a highly profitable business as the costs are limited. Qualcomm’s licensing division reported over $5 billion in revenue in 2020.

Identifying Moats

It is often difficult to identify an economic moat when it is being created. It becomes more clear in hindsight, as the company reaches major heights. But still, if you observe closely, you will be able to identify the significant advantage of a company.

An important aspect that distinguishes an advantage from a moat, is sustainability. The moat should be sustainable. If it is something competitors can replicate, the moat wouldn’t last long. And the longer the company can keep the moat, the greater the profits. So whenever looking at a company make sure the competitive advantage is sustainable.

An efficient products and services ecosystem is another sign that a company might be creating a moat for itself. Especially an ecosystem that benefits from the network effect that we discussed earlier. This is more often found in internet companies.

Another sign that a company is achieving a moat, is when the name of the product or service becomes a verb, or sometimes the category itself. Take Google for example. Nobody search for stuff on the internet anymore – they ‘Google’ it.

Bottomline

Successful companies are built on sustainable competitive advantages. So as an investor it makes perfect sense in looking to companies with economic moats. That’s not to say that every company that does have a moat will be a bad investment. Just that investing in companies with a moat increases the odds of substantial profits from the investment.

As a comprehensive continuation to this article, we’ll soon be releasing a book on Moats; how to identify a moat while it is being created, how to approach companies with an established moat, etc.

To make sure you don’t miss out on the book, join our newsletter here.

Book value; What it means to investors in 2021

When it comes to valuing a company and deciding whether it would be a good investment or not, things can get a little tricky. Of course, there are a lot of metrics you can look at, but it can be intimidating if you’re not sure what you’re looking at.

For instance, you’ve probably heard about the market cap of a company. Most investors look at this metric to understand how large a company is.

But there’s another metric you can look at, which gives you an exact picture, of what a company is worth. It’s called the book value of a company.

Let’s look at it in detail.

Book Value of a company 

The book value (also known as net book value) of a company is, simply its assets minus its liabilities. It tells you how much the company is worth as per the company’s balance sheet.

Book value can also be seen as the amount left after paying off its liabilities, in the event of a liquidation.

Let’s say you invest in a company, and a year later the company closes down its business. As an investor, you have a right to claim a portion of the company’s assets. Instead of giving you your share of assets, they’ll sell off all the assets first. The company’s assets will be liquidated (sold off) and using the money, all the liabilities the company has incurred will be paid off. What’s left will be distributed to the shareholders, including you.

This total amount the shareholders will receive after paying off the liabilities is referred to as the book value of the company. In other words, a company’s book value is its basic net worth.

To easily calculate the book value, deduct the total liabilities a company has, from its total assets.

Book Value Formula: Assets – liabilities

For example, Apple Inc. (AAPL) has total assets of $323.88 billion and total liabilities of $258.54 billion. So their book value is $65.33 billion ($323.88 billion – $258.54 billion).

In the company’s balance sheet, you find the same number listed as shareholders’ equity.

Market value and Enterprise value

Now, book value is different from market capitalization or enterprise value. Market cap is the total value of a company’s outstanding shares. It is the perceived value of the company by the investors. For example, Fiverr has a current market price of $174.65, with 35.84 million shares outstanding. So that makes Fiverr’s market cap around $6.26 billion ($174.65 * 35,840,000).

Whereas enterprise value will be calculated in a different way. Enterprise value is the theoretical takeover price of a company. So it is calculated by adding its market value, and liabilities together and subtracting cash the company has. So in the case of Fiverr, that’s ($6.26 billion + $380.21 million) – $441.84 million. That gives Fiverr an enterprise value of $6.28 billion.

Now you see how these metrics are all about the value of the company still have entirely different values.

Components of Book value

A company’s book value is the value of the business according to its accounts (books). It is the net asset value of the company. This is seen from the perspective of what would the investors get if the company was liquidated. So that’s after liquidating all the assets and paying off the liabilities.

Total Assets

Assets include short and long-term investments, cash and cash equivalents, and all other kinds of financial assets. It also includes physical assets such as plants, equipment, and machinery.

Intangible assets such as patents, copyrights, and other intellectual property are also considered under total assets, but most often due to their intangible nature, cannot be represented in the company’s balance sheet.

Total liabilities

Liabilities include short and long-term debt, accounts payable, deferred taxes, and other obligations.

In a healthy balance sheet, the assets should be more than liabilities.

Using Book Value in valuations 

All of this information wouldn’t mean anything unless we can use it in valuing companies.

So, let’s take a look at how we can do that.

Book value per share

Book value per share is calculated by dividing the book value of a company by the number of shares outstanding. So in the case of Fiverr, the book value per share would be $9.52.

Price-to-Book ratio (P/B ratio)

This is one of the oldest metrics used by investors in valuing a company. The price to book ratio is calculated by dividing a company’s stock price by its book value per share. So if a company has a share price of $50 and it has a book value per share of $25, then the P/B ratio would be 2.

Limitations of using Book value

Like I mentioned above, book value is one of the oldest metrics used by investors. It was more suited for those days when most of the company’s assets could be accounted for on its balance sheet.

Today, however, that’s not the case.

Especially with modern companies, a lot of their assets are intangible in the form of brand value (Apple), patents (Qualcomm), data (Google), etc.

So when calculating ratios such as the Price to book ratio, the company might seem significantly overvalued. And that can often discourage investors, when in fact, a lot of their assets just cannot be quantified.

Another factor that should be considered while valuing a company is its profitability. A company with an excellent product and a growing business is most likely a good investment. The stock might be trading above its book value, but that’s just because profitability and future growth are taken into account by the investors.

This is the reason you should look at more metrics when valuing a company, and not restrict yourself to one specific metric.

Value investing and Book value

Value investors are in constant pursuit of undervalued stocks. P/B ratio used to be the guiding light for value investors, as the metric immediately revealed whether a stock was undervalued.

But not anymore.

Value investing has evolved over the years, and what exactly constitutes value investing has been a topic for discussion in the investing community. In a time where most companies have high valuations even before they are profitable, checking the book value to see whether the stock is undervalued, might not be a smart move. Especially when you considered the increasing importance of intangible assets.

Value investors, today, look at more relevant metrics and they look at the sector in which the company is. Because companies in certain industries can have high P/B ratios compared to other industries. For example, internet companies.

Bottomline

There’s no doubt that book value is an important metric in a company’s valuation. But it should not be considered as the key to unlocking undervalued stocks. It’s always better to look at more metrics before you arrive at a conclusion. As for comparison, look for companies in the same sector, that’ll give you a better idea.

And remember, it’s better late than never. So if you haven’t started investing yet, start today. Meanwhile, here’s a guide to help you do that – The 8-Step Beginner’s Guide to Value Investing.

Enterprise value; Definition, importance, and calculation

What is enterprise value (EV)?

In its simplest form, enterprise value (EV) is the theoretical takeover price of a company. Meaning, it is the company’s market value, which you need to pay for acquiring it.

A company’s enterprise value is seen as a comprehensive alternative to its market cap and is mostly used in Mergers and acquisitions, as it gives an estimate of how much the buying entity must pay to take over the company. Enterprise value is a better alternative to market cap since it considers both the debt and the cash on the company’s balance sheet.

This is is how you can calculate enterprise value –

Enterprise Value = (Market cap + debt) – cash

Market capitalization (also known as equity value) is the company’s perceived value by the stock market participants. It is calculated by multiplying the company’s stock price by the number of outstanding shares (shares that are available to the public to trade). And that is basically the total value of all the shareholder’s stakes in the company. So if you want to take over the whole company, that’s what you need to buy first.

Second, comes debt. Once you acquire the company, whatever debt the company has, is your responsibility, and would need to pay that off eventually. So that’s is added to the total cost of acquisition.

The next is cash. And that’s deducted from the total cost. Because whatever cash the company has, it’s yours once you take over the company. That cash can be used to repay some of the debt. So it makes sense to deduct it from the total amount you need to pay for the company.

Components of Enterprise value

Market capitalization

Market capitalization can be calculated by multiplying the number of outstanding shares by the share price.

For example, if a company has 50 million shares outstanding, and the share price is $100, then the market cap is $5 billion (50 million shares x $100 per share).

Preferred stock

Preferred stock is technically equity. But depending on how it is issued it can also act as debt. For example, a preferred stock that must be redeemed at a future date at a certain price is, by all definitions, debt. And in most instances, preferred stockholders are entitled to a larger fixed dividend compared to common stockholders. They also have a higher priority in asset and earnings claims.

Since the preferred stock has a larger claim on the business, the holders must be repaid in a takeover. So similar to debt, it is taken into account when calculating the enterprise value.

Debt

Acquiring a company equals, acquiring everything the company owns and owes.

This includes both long-term and short-term debt. So once you’ve taken over a company, it is your responsibility to pay it back to the creditors. Let’s say a company is worth $50 million, and the company has $10 million in debt. So even after you pay $50 million to buy the company, you still need to pay off the debt, which is an additional $10 million. So your total cost is $60 million.

This is the reason debt is added to the enterprise value of a company.

Cash

When you acquire a company, the cash is yours to use, just like the debt is yours to pay.

This includes cash in the bank and other cash equivalents, like short-term debt and marketable securities. Cash reduces the acquisition price. As cash is the most liquid asset the company owns, it is assumed that the buyer will use it immediately to pay off a portion of the debt. So cash is deducted from the enterprise value.

What is the use of Enterprise value?

Enterprise value in investing

Enterprise value is used by investors to value a company. Especially investors who follow the value investing strategy, often use enterprise value as a metric to compare companies in the same industry.

Investors also use the EV/EBITDA also known as the EV multiple, in valuing a company. EBITDA stands for earnings before interest, tax, depreciation, and amortization. EV multiple is often used as an alternative to the traditional P/E ratio.

Unlike the P/E ratio, EV/EBITDA takes into account debt and the cash the company has.

Enterprise value in Mergers and Acquisitions

Enterprise value is very useful in mergers and acquisitions. In fact, enterprise value is considered a more accurate measure of the value of a company compared to its market cap. The reason being, enterprise value takes debt into account, which must be paid by the buyer when acquiring a company.

Because two similar companies with the same market cap can have different enterprise values.

If a company has a market capitalization of $100 million and $10 million in cash and no debt, its enterprise value will be $90 million ($100 million + zero debt – $10 million cash).

Meanwhile, an identical company that has a market cap of $100 million and $20 million in debt, and $5 million in cash, will have a market cap of $115 million ($100 million + $20 million – $5 million).

In this scenario, we can see that the first company is cheaper to acquire, since it does not have any debt to pay off, and they have spare cash.

Consider the examples of Advanced Micro Devices (AMD) American Airlines (AAL). AMD has an enterprise value of $130 billion which is less than its market cap ($134 billion). Whereas in the case of AAL, the company has a market cap of $12.8 billion and an enterprise value of $43.19 billion – almost 4x its market cap!

The reason is American airlines have a lot of debt and as a result, you need to pay a lot more than its market value in order to acquire the company. AMD, however, has very little debt, and as a result, has an acquisition price (enterprise value) that is less than its market cap.

And as you can see, enterprise values can also be used to compare companies with different capital structures. Capital structure is the combination of capital that is used to fund a company. That includes shareholder equity, debt, and preferred stock. And a difference in capital structures can affect the enterprise value.

There are some downsides to using enterprise value in the valuation of a company. When using enterprise value, a company with a relatively high amount of debt might be seen as less of a prospect than a company with less debt. What many fail to realize is that their competitors also have similar levels of debt.

A better way to use enterprise value when valuing a company is to look at other companies in the same industry.

How can you use Enterprise value?

Even if you don’t want to take over a company, you can use EV multiple in valuing companies. Remember, it is a more accurate representation of what a particular company is worth. And you can use it to identify whether the company is overvalued or undervalued.

A low ratio relative to peers might indicate that the company might be undervalued, and a higher ratio means the company might be overvalued. Then again, companies in high-growth industries tend to have a higher ratio compared to companies in slow-growth industries.

Ideally, when using EV multiple, you should compare the ratio of a company with similar companies in the same industry.

Key Takeaways

  • Enterprise value is the total takeover price of the company. It includes the equity and debt capital of the company.
  • It is mostly used in Mergers and acquisitions as it provides an accurate cost of acquiring a company.
  • Enterprise value can also be used by individual investors in comparing companies within an industry.

To learn more about valuing companies, check out our bestselling book The 8-Step Beginner’s Guide to Value Investing.

Value trap; How it works and how to avoid in 2021

Value investing is one of the most popular investment strategies. The stock market has rewarded value investors with exponential returns. No wonder why so many new investors are intrigued by this successful strategy.

However, there is one aspect that many investors look over and fall prey to – the value trap.

Let’s see what it is.

What is a value trap?

It is precisely what the name says – a trap.

Value traps are stocks that seem like value stocks but are actually traps in disguise. These stocks will be trading at low stock prices relative to what is considered as their fair value (or book value), and will also have valuation ratios in lower multiples. This will trick an investor into thinking that it is a value stock available at a discount.

Value traps appear to regular investors as potential winners, especially for value investors who are looking to buy stocks on a bargain. But in reality, these stocks often have very little promise, and possibly no future. Investors on seeing this ‘opportunity’ rush to buy these stocks end up losing their money.

The catch here is that the stock price is low not because it is trading below its intrinsic value. It’s just because the company doesn’t have much potential and is likely to be on its way to bankruptcy.

How does a stock become a value trap?

To understand this, let’s first look at how a regular stock becomes a value stock. This happens when a stock that has strong fundamentals and huge long-term potential trades below its intrinsic value. This might be because the market hasn’t realized the stock’s true value, and when it does, the stock price rises above its intrinsic value, and the investor makes money.

However, in the case of a value trap, the stock might be trading at a low price because of different reasons. It might be the case that the company’s long-term outlook has changed, or is about to change due to reasons that are not immediately apparent. The stock might appear to have good fundamentals, but there are underlying issues that could potentially affect the long-term prospects of the company.

For example, a company losing market share to a strong competitor might be at the risk of losing out revenue and profits – which could have a negative impact in the long run. But this might not be obvious in the income statement or balance sheet.

Value trap indicators

There are various instances where a stock might end up being a value trap. A factor that indicates that a particular stock might be a trap is referred to as a value trap indicator.

Let’s look at each in detail;

Earnings and cash flow

Income and cash flow statements are something every investor looks at when analyzing a company’s fundamentals. However, an income statement or a cash flow statement doesn’t tell you the whole story. A company can have good earnings and still go bankrupt.

Consider the case of some investment banks at the time of the financial crisis during 2008-2009. These institutions were funding long-term liabilities with current assets. So their financial statements looked healthy, but they were hanging by a thread. Soon enough, most of these institutions went bankrupt, and the shareholders were wiped out overnight.

Business model

This is something that many investors neglect and as a result, can lead you right into a value trap.

In a nutshell, understanding the business model involves finding the answer to three questions; a) how do they make money, b) how do they spend their money, and c) and what makes them any different from a competitor.

If there’s a company whose business model is hard to understand, and you can’t find a path to profitability, it might not be worth investing in it. Another question to ask  – is the business model sustainable? Meaning can it withstand a recession, technological advances, etc.

Walmart is a great example of a company that can withstand a recession and technological disruption.

Major changes in the industry

Changes are inevitable, and they happen all the time – some of them are obvious, while some aren’t. Major changes in an industry can change the long-term outlook of a company, in a short period of time. More importantly, these changes won’t be reflected in the financials of the company until a few quarters or years later. Meanwhile, investors will rush to buy the stock as it seems cheaper compared to its previous prices.

Airlines are a good example of this. The global pandemic brought a lot of change to the airline industry – because people stopped flying. And then people found a way to reach one another without traveling hundreds of miles – using Zoom and other video conferencing platforms. If you were an investor who has been waiting to own airline stocks, you see the price decline the pandemic has caused, and you jump at the opportunity.

Guess what, you’ve just fallen prey to a value trap.

Peak earnings or cyclical industries

Then some companies belong to cyclical industries. A cyclical industry is an industry that is dependent on business cycles for revenue generation. So their profits rise and fall predictably. The businesses in cyclical industries, expand and contract, and expand and contract again – in cycles. Their ability to make money largely depends on the overall economic conditions. Hotels, textiles, and construction are some examples of cyclical industries.

When they go through a favorable period in the business cycle, their earnings might shoot through the roof. This results in a significantly low P/E ratio, which makes the stock appear largely undervalued. Now given the fact that most investors look at the P/E ratio to find undervalued stocks, suddenly these stocks might seem like a lucrative investment. However, investors fail to realize that this might be the first time they’ve had such results in years or even decades.

Management

This is another aspect of a company that gets lost in the world of numbers, ratios, and whatnots. Good management can build the company from the ground up and keep it growing, and a bad one can drive it right into the ground. The management makes strategic decisions that decide the long-term potential of a company. So be well aware when they are giving out signals.

Are the insiders buying shares? Or are they selling them? Do they have skin in the game – how much of the shares do the executive team members own? These are some questions you need to ask yourself, before jumping into a value stock – to make sure you don’t end up in a value trap.

Chewy – one of the stocks that we recommended has insider ownership of 21.99%. It means that about 22% of all the outstanding shares are owned by the company’s management, directors, promoters, etc. basically people who know best about the future of the company. Significant insider ownership ensures that they have skin in the game – they are accountable for their actions that drive the company.

Companies without a moat

Okay, you have checked all of the boxes above  – they have a good business model and management, they’re not in a cyclical industry – it all seems good. But are they any different from their competitors? More importantly, is there anything that sets them apart from their peers in the industry? What if a new competitor comes in – can they imitate what our company does – what if the competitor does it in a better way?

The point is – if they don’t have sustainable competitive advantages (also known as moats), that can set them apart from their competitors, they’re unlikely to survive competition over the long run. And they could just be another value trap.

Consider Apple for example. If you’re an iPhone user (or any Apple products for that matter), you know best about the edge Apple has over its competitors. Their brand value is just one of their sustainable competitive advantages that just cannot be imitated by their competitors – new or old. And if you’re not an Apple user, you know how the prices seem ridiculously high – but still, people line up outside their store whenever they launch a new product. That’s because of the pricing power that they have; they can charge higher prices than their competition and still get away with it, without losing market share.

How to use value investing to avoid value traps?

Now that we know the characteristics of a value trap, let’s see how you can avoid them.

Do your homework; thoroughly

I can’t stress this enough.

You need to do due diligence on any stock that you buy, and you need to do it thoroughly.

That means not just looking at the numbers, but doing a deep dive into their 10-K form, investor presentations, etc. When they hear about a stock for the first time, most investors quickly jump onto a platform like Yahoo Finance and take a look at all the numbers available – P/E, P/B, P/S, ROE, ROA, ROIC, etc. and decide whether its a good or bad investment.

Don’t get me wrong here; it’s a good idea to look at numbers, and Yahoo Finance is a great place to start – as it gives you a detailed look without being intimidating. But you shouldn’t make an investment decision solely based on that. Because that might just be the easiest way to end up in a value trap.

You see, the numbers only tell you one side of the story. There might be underlying issues that pose a risk to the future of the business – the company might be facing a lawsuit from their biggest customer, they might be losing market share, or their products are getting outdated, etc. Therefore, wait for a while to make sure you’re not buying on ‘instinct’. And in the meanwhile, take a look at their investor presentation – it is usually short and easy to understand. And if you’re still interested, take a look at their Form 10-K. That will give you a detailed look at the business and operations.

And always remember, if you can’t find some sort of negative information about the company, you haven’t looked deep enough. Now, this information needn’t necessarily be bad enough to sell the stock, but more like the kind of information that gives you a fair picture of the risks of investing in the company.

Bottomline

Investors should be well aware of the risk value traps pose. This is especially applicable for value investors, as they’re the ones who are more exposed to these. There is also the risk of buying stocks by looking only at dividend yield, only to end up in value traps.

It is important to note that, Warren Buffett, however, had the audacity to identify false value traps (which is nothing but a value stock) and make a lot of money. The important part is being able to tell the difference between a value stock and a value trap.

To know more about value investing and the 20 stocks you should buy for the long term, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.