What Exactly Is Value Investing?
Selecting stocks that appear to be trading at a discount to their intrinsic or book value is the goal of value investing. Those who invest in value do so with the intention of finding stocks they believe the market is undervaluing.
They hold the view that stock price fluctuations do not reflect a company’s long-term fundamentals because the market overreacts to both positive and negative news. By taking advantage of the market’s overreaction, you can buy stocks at bargain basement prices.
In addition to Benjamin Graham (Buffett’s professor and mentor), David Dodd, Charlie Munger, Christopher Browne (another Graham student), and billionaire hedge-fund manager Seth Klarman, there are many other prominent value investors working today.
Check out this article on how Warren Buffett picks his stocks. Every trader should know this
KEY POINTS
- Picking stocks that appear to be trading for less than their intrinsic or book value is the goal of value investing.
- Investors who focus on value are on the lookout for stocks they believe the market is undervaluing.
- Value investors are those who invest in high-quality companies over the long term using financial analysis and who avoid investing with the crowd.
Value Investing: What You Need to Know
Everyday value investing is predicated on a simple tenet: you can save a ton of money by purchasing items on sale if you know what they’re really worth. You can get the same screen size and picture quality from a brand new TV whether you buy it on sale or at full price, according to the vast majority of consumers.
The same is true of stock prices; they can fluctuate even if a company’s value or valuation has remained constant. As with televisions, stock prices rise and fall in response to fluctuations in supply and demand, but the value you receive remains constant.
Value investors are similar to savvy shoppers who would argue it is silly to pay full price for a television given that televisions go on sale multiple times a year. Obviously, stocks won’t go on sale at regular intervals like Black Friday, and their discounted prices won’t be publicized.
As a value investor, your job is to use your sleuthing skills to uncover under-the-radar stock sales and make bargain purchases below the stocks’ current market prices. Investors who buy value stocks and hold on to them for the long term often reap substantial rewards.
IMPORTANT
When a stock’s share price is lower than it should be, it is said to be undervalued. Value investors try to make money by purchasing stocks they believe are undervalued.
In order to determine a stock’s true worth, or valuation, investors use a number of different metrics. Intrinsic value is calculated by looking at a company’s brand, business model, target market, and competitive advantage in addition to its financial performance, revenue, earnings, cash flow, and profit. Values for a company’s stock can be derived from a variety of factors, including:
- Value of a company’s assets as compared to its stock price is its “book value,” which is measured by the price-to-book ratio (P/B). Assuming the company is not in financial distress, undervalued stock would have a price lower than the value of its assets.
- One way to tell if a stock is over- or undervalued is to look at its price in relation to its earnings potential, as measured by the price-to-earnings ratio (P/E).
- To put it simply, free cash flow is the amount of money left over after all expenses have been paid for. After paying for all expenses, both operating and capital, or large purchases like equipment or a factory upgrade, free cash flow is the amount of money left over. Having free cash flow allows a company to reinvest in its future, reduce its debt load, reward its shareholders monetarily, and repurchase its own stock.
Debt, equity, sales, and revenue growth are just a few of the many metrics used in the analysis. If the value investor finds the stock’s current price to be attractive relative to the company’s intrinsic value after considering these metrics, the value investor may decide to make a purchase.
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Margin of Safety
As a result, value investors need a “margin of safety” to account for potential mistakes in their valuations, which they determine based on their own comfort level with risk.
One of the most important aspects of value investing is the margin of safety principle, which states that investors who buy stocks at discounts have a greater chance of making a profit when they eventually sell their holdings. If the stock doesn’t do as well as expected, you won’t lose as much money thanks to the margin of safety.
These same lines of thinking are employed by value investors. You can make a profit of $34 by simply waiting for the price of a stock you purchased for $66 to reach its true value of $100.
Plus, the company’s growth and increased value could eventually lead to even greater financial rewards for you. Since you purchased the stock at a discount, any increase in price to $110 would result in a $44 profit. Only if you bought it for $10 less than its original price of $100 would you have made a profit.
Keep an eye on this space for part 2 on value investing.
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