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2 Important Factors in Finding Winning Investments

Happy Hump Day! The Great Singapore Sale is into its final week.

From what I observe on Orchard Road, most shoppers here know a bargain when they see one. Thing is, investing in stocks is not too different too. If we want our stocks to gain, we have to buy it a stock price that is below what its underlying business is worth.

In other words, we should try putting a value in a business before we buy its shares.

Thinking value

One way to do so would be to consider the value of a business as the present value of all its future cash flows. I have written about the concept before in here.

But what can affect this value? To help arrive at an answer, I will turn to a paragraph from Pat Dorsey’s The Little book that Builds Wealth. Dorsey used the example of a landlord’s apartment to draw parallels to a common business that you may get to buy shares of in the stock market:

“Let’s think about what would make a building full of rental apartments worth more or less to a prospective purchaser.

Growth would certainly push the value up—if a building had an adjacent patch of land on which a landlord could build more apartments, it would be worth more than a building without that land, as the stream of potential future rental income would be larger.

The same goes for the riskiness of the rental income—a building full of seasoned wage-earners would be worth more than the same building full of college students, because the landlord would be more confident of actually collecting the rent each month without a big hassle.”

In Dorsey’s example, he pointed to two important factors that can affect the value of a business: Growth and Risk. If the company is able to expand its business, the value of our shares may rise. On the other hand, if its business is easily threatened by fickle customers or new disruptive trends, its value may dwindle (and drag our shares along with it).

Let’s try putting on our thinking hat for BreadTalk Group Limited  (SGX: 5DA).

As an operator of multiple food & beverage retail brands like its namesake bakery, Toastbox, and Ding Tai Fung, there are a number of ways that BreadTalk is able to expand its business (this is the growth factor). This gives the investor hope that the value of the company may rise if its profits can grow as it moves along its multiple avenues for growth.

But, BreadTalk has struggled to maintain its profit margins (the risk factor) over the years as it expanded and you can see this in the chart below. It is certainly a point of concern for shareholders if BreadTalk loses a grip on its profit margin as that can negatively affect the value of the company.

Breadtalk Group's net profit margin

Source: S&P Capital IQ

A Fool’s take

Considering the growth factor and risk factor of an underlying business are two ways to think about the value of companies. Keeping these factors in mind may help us make a better judgement on whether a company’s shares are overpriced or underpriced.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.