With the S&P 500 down more than 13% since the beginning of the year, investors have painfully relearned the lesson that stocks can go down as well as up. Especially when the market as a whole drops more than 3.5% in a single day, the fear in the market is palpable.
Add the fact that rising interest rates can play havoc across multiple asset classes, and you get a set of conditions that could lead to a tough market for investing new money.
That raises a key question: Is this really the right time to invest in the stock market? Between investors’ current fear and the structural impact of rising interest rates, it certainly seems on the surface that now would be a terrible time to invest.
Yet if you are personally financially prepared and have the right mindset, now might actually be a great time to start seeking out bargains among stocks in today’s market.
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How to be personally financially prepared
In order to be in the position to successfully invest in a potentially rocky market, you need to have your own financial house in order. Your debts should be at low interest rates and easily covered by your cash flows. That way, you’ll be less at risk of selling while the market is down due to worry or a need to cover your bills.
In addition, you should have the mindset that you’re seeking to own the shares you’re buying for at least five years. The objective with that is not to force you to own your stocks for that long, but rather to get you thinking about the businesses behind those stocks and what they’re really worth. That state of mind will help you better recognize whether further drop-offs in a company’s stock price are a sign that its strategy is failing or whether it is simply becoming a better bargain.
To support that mindset, you should also be in a position where you don’t need to sell your stocks to cover your costs over the next five years. That can come through having income from another source (like working) or through having a large stash of cash or higher-certainty investments like CDs or an investment-grade bond ladder. That way, if the market continues to struggle, it’ll be easier to have the patience you need to wait things out until stocks start to recover.
How to seek out bargains
If there’s an upside to a down market, it’s that it makes the stocks of solid companies cheaper than they had been, when compared to those companies’ long-term prospects. After all, a share of stock is ultimately nothing more than an ownership stake in a business. That business can be valued based on its cash-generating ability. While those valuations are only estimates, they can often be good enough to figure out when a company truly looks like a screaming bargain.
The key is to leverage something known as the discounted cash-flow model to build your valuations. You start by estimating how much cash the company is going to generate in the future. Next, you assess how risky that cash flow projection is. With that projected cash flow and risk assessment, you then dial back (or “discount”) the value of those future cash flows based on that risk.
For instance, if you estimate that a company will generate $1 million in cash next year and your risk assessment suggests you need a 10% return on your investment, that $1 million would be discounted to $909,090.91. If the company is expected to generate another $1 million the year after that, that second year’s cash flow would be discounted to $826,446.28. Those numbers represent the cash you need today to end up with the earnings you expect in the future if you earn the rate of return you’re discounting it by.
In other words, multiply $909,090.91 by 1.1 to represent a 10% return for one year, and you end up with $1 million. Multiply $826,446.28 by 1.1 twice to represent a 10% return compounded for two years, and you end up with $1 million.
Add together all those discounted future cash flows, and the result is your best estimate of the fair value for the company. If its market capitalization is below the valuation estimate you generated, then the company looks like a potential bargain.
If you find one, it’s worth double-checking to make sure the market isn’t factoring in a large risk that your model missed. If after you double-check, you remain convinced that the company looks like a bargain, it might very well be worth buying as part of your overall portfolio.
Get started now
Because you need to prepare your personal finances before you invest in a market as rocky as this one is likely to be, it makes sense to get a jump on things as quickly as you can. By getting that foundation in place, then starting your bargain-hunting, you just might find that now really can be the right time to invest in the stock market.
Just be sure to have the patience it takes to wait out what could very well be a rocky near term for even the best bargain stocks.
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Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
