Stock Investing: A Guide to Value Investing

It is a strategy that involves picking stocks that are trading at a cheaper price than their intrinsic value.
 

One of the most widely-followed and well-respected methods of investing, famed by arguably the greatest investor of all-time Warren Buffet, is value investing. This method of investing has increased in popularity due to the astounding results it has provided for investors.

Value investing is a strategy that involves picking stocks that are trading at a lower price than their intrinsic value. Value investors look for undervalued stocks by seeking companies that the market has priced incorrectly. 

Value investors do not believe in the efficient market hypothesis because their whole strategy relies on the inefficient market. Market overreactions happen all the time and are why the market is inefficient.

Every once in a while, the market will overreact to good or bad news and price a stock differently from its actual worth. 

This means that sometimes people will sell their shares of a stock because of bad news that came out, causing the share price to drop even if the company's intrinsic value did not change. 

Value investors aim to take advantage of this mispricing by buying stocks for cheaper than they are truly worth. If they are correct about the value of the stock, then once the market realizes that the stock is priced too cheaply, the investor will get a great return. 

These investors analyze the financial statements of companies to determine the intrinsic values, then compare those with the trading prices of the companies. This takes a lot of patience and dedication, but the rewards are well worth it. 

Value investing comes from Benjamin Graham's book "The Intelligent Investor." Graham was the mentor to Warren Buffet and the person to who Buffett credits his success. Without Graham, the idea of value investing might not even exist today. 

Graham's original idea of value investing is a lot different than Buffet's style that he uses today, but the fundamentals of the strategy come from Graham's book. 

Understanding value investing

The basic concept of value investing is simple; you buy stocks on sale to save lots of money. If you know the true value of something, then why wouldn't you buy it if it was on sale for less than its true value?

The hard part of this style of investing is staying disciplined. When the market is going down and everyone is freaking out, it can be very hard to put your own money in. 
Even though it's challenging to ignore the noise and continue to buy when the outside world is convinced all stocks are going to zero, this is the best time to find great stocks on sale. 
When it comes down to it, the stock price is largely determined by higher and lower demand fluctuations. So if the demand for TVs falls and the price of a TV becomes cheaper, this doesn't mean the quality of TVs is going down.
This is the same for stocks during a market correction or bear market. Just because the price of a stock is going down does not mean the intrinsic value of the stock is decreasing. 
You should get excited when the price of a stock you want to buy goes down because then you can buy it for cheaper. For example, wouldn't you rather buy a television on sale than pay full price for the same TV?
 

The tricky part is unlike TVs; stocks do not go on sale at predictable times. Savvy investors have to find when stocks go on sale by reading financial statements and determining companies' intrinsic values to find when they are trading for less than the true value.

Stocks become undervalued due to market overreactions. Value investors have to remain level-headed and not be swayed by the public when it comes to market reactions. People often buy stocks high out of greed and sell low out of fear.

Value investors ignore emotion and use logic to exploit other people's fear. When people are selling stocks for less than intrinsic value, intelligent investors will take advantage of this and buy when everyone else is fearful. 

Warren Buffet said, "Be fearful when others are greedy and be greedy when others are fearful," which shows that the best investors are not swayed by public opinion. 

Traditional value investing basics

Ben Graham is known as the father of value investing. 

In his book "The Intelligent Investor," he came up with a method of screening stocks that involved finding stocks with a trading price lower than intrinsic value. His method was not overly complicated or intricate and could be used by any average investor. 

The main criteria that Ben Graham looked at to determine if a stock had an intrinsic value greater than its market price were:

  • P/B ratio of 1 or lower
  • Price to earnings (P/E) ratio of less than 40% of the stock's largest P/E ratio in the last five years
  • The share price of less than 67% (two-thirds) of the tangible per-share book value and less than two-thirds of the company's net current asset value (NCAV). 
  • Total book value greater than total debt 
  • Total debt should not exceed twice the NCAV, and current liabilities/long-term debt should be less than the firm's stockholder equity.

These criteria were useful to Graham, but every investor has a different opinion on the best criterion to use. For example, some investors use only the P/B ratio to determine whether or not a stock is undervalued. 

It is important to note that Graham's method only focused on finding undervalued companies; he did not care if they were good companies. Buffet differs from this method because Buffet looks for undervalued companies, not just cheap ones.

Graham also created his alternative valuation metric known as the Graham number. The formula for calculating the graham number is: 

formula

The square root of (22.5 x (Earnings per share) x (Book value per share))

For example, a stock with an EPS of $1 and a book value of $5 per share would have a Graham number of $10.61. 

This number is designed to represent the actual per-share intrinsic value of the stock. You can compare it to the stock price to determine the following:

  • If the current share price is lower than the calculated Graham number, then the stock is undervalued 
  • If the current share price is higher than the Ben Graham number, then the stock is overvalued

This is a very simplified way of determining the value of a stock. The basic concept works, but many other factors can affect a company's intrinsic value, so there are more complex ways of determining the value that we will explain in further detail. 

Determining value

Value investors continue to give Graham's methods for valuation attention, but we have seen a variety of new valuation methods gain attention over the past few years. 

The Discounted Cash Flow (DCF) formula is an increasingly popular valuation technique. The DCF formula is one of the few metrics to consider the time value of money, making it a favorite of many financial professionals and accountants. 

Discounted cash flow analysis uses future free cash flow projections and discount rates to estimate the present value of a company. It does this based on the company's ability to generate cash flow in the future, which is a major factor in determining the intrinsic value. 

The calculation of a DCF is derived from the present value formula for calculating the time value of money and compounding returns. The discounted present value formula is: 
 

DPV

  • DPV = the discounted present value of the future cash flow (FV) 
  • FV = the nominal value of a cash flow amount in a future period.
  • r = the interest rate or discount rate, which reflects the cost of tying up capital and may also allow for the risk that the payment may not be received in full
  • n = the time in years before future cash flows occur 

If the DCF analysis comes out to be higher than the share price, then the stock is undervalued. 

Discounted cash flow analysis is well-suited for evaluating companies with predictable cash flows. Its weakness is that it depends on accurate estimates of future cash flows. 

Since predicting future cash flows is not always easy, some professionals prefer to use a reverse DCF to avoid having to project future cash flows. A reverse DCF starts with the current share price. It then calculates the cash flow needed to generate that current valuation. 

Once the required cash flow is discovered, the company's valuation is determined simply by a judgment call. If it is reasonable that the company can easily generate the required cash flow necessary to sustain the share price, then the company is probably undervalued. 

If it is unreasonable to say that the company can generate the required cash flow needed to sustain its share price, then it is probably overvalued. 

Alternative methods of determining the value

In addition to the DCF analysis, other alternative methods exist to determine intrinsic value. One method is Katsenelson's absolute P/E model. 

Katsenelson's model, developed by Vitally Katsenelson, is a tool that is considered ideal for evaluating companies that already have well-established earnings that are strongly positive. 

Katsenelson's model is considered a more reliable version of the P/E ratio, which looks at a company's share price compared to the earnings per share. 

The "absolute P/E" is superior to the regular P/E ratio because it adjusts the P/E in accordance with several variables, such as earnings growth, dividends, and the predictability of earnings. The formula for absolue P/E/ is: 

Absolute PE = (Earnings growth points + dividend points) x [1+ (1 - business risk)] x [1 + (1 - financial risk)] x [1+(1-earnings visibility)] 

Earnings growth points are determined by adding .65 points for every 100 basis points. The projected growth rate increases to a no-growth starting P/E value of 8. 

You keep adding .65 points for every 100 basis points until you reach 16%. Once above 16%, .5 points are added per 100 basis points. 

The final absolute P/E value is then compared to the traditional P/E value. If the absolute P/E is higher than the standard P/E, that tells you the stock is undervalued. This is because the absolute PE indicates how much investors are willing to pay for the company's earnings. 

The larger the discrepancy between absolute P/E and standard P/E, the more undervalued the stock is. 

For example, if the absolute P/E of a stock is 25 and the standard P/E is 15, then the stock is likely to trade at a great bargain because the absolute PE indicates that people are willing to pay a lot to own shares in the company. 

Strategies of value investing.

Like every type of investment, strategies for value investing differ among each individual. However, there are some generally accepted principles used by all value investors. 

These principles have been famed by legendary investors such as Warren Buffet, Charlie Munger, Peter Lynch, and many more. These strategies consist of: 

  • Buy businesses, not stocks
  • Love the business you invest in
  • Only invest in companies you understand
  • Find well-managed companies
  • Ignore the market 

Buying businesses, not stocks, means that you should ignore trends in stock prices and market noise. Instead, value investors should look at a company's fundamentals rather than solely the stock price.

While you can certainly make money by following trending stocks, this is not the strategy used by value investors. It requires too much activity and tracking of the market, and value investors would rather spend their time searching for good businesses selling at good prices. 

Love the business you invest in means you should only buy businesses you know everything about and are passionate about. You should look at the business' bare financials beyond just their basic P/E and P/B ratios to understand what is going on.

If the company's financials look just as good bare as they dress up in fancy ratios, it is more likely to be a good business. 

When investing in businesses, you understand a key rule for value investors. This style of investing requires a prediction of future earnings, so you must understand the business to make an educated guess about its future earnings. 

Finding well-managed companies is important for value investors because management can make a huge difference in a company. Good leadership can add value to a company, whereas bad management can destroy even the most financially solid companies. 

Warren Buffet suggests that investors should look for management with integrity, intelligence, and energy. Reading several financial statements over the years, you can get a sense of the management's honesty by looking at how well they delivered on past promises. 

Ignoring the market is a helpful practice for value investors to follow because it helps them avoid the noise and trends of the market. For value investors, the market only matters when they enter or exit a position. The rest of the time should be ignored. 

When you sell a stock, you lose a portion of the return due to capital gains tax. As a result, you forestall capital gains on your portfolio by holding investments with unrealized gains longer. Because of this, you should be just as slow to sell a stock as you are to buy one. 

Financial benefits of value investing.

At this point, you are probably wondering, "can I get rich from value investing?" 

Well, the short answer is yes. 

If you stay dedicated to the rules and strategies above and have enough patience to ignore market trends and wait for the perfect time to buy, you will become very wealthy. Value investing is all about being patient, but the rewards of compound interest are well worth it. 

Warren Buffet is one of the top five wealthiest people in the world, and he made all his fortunes through this investing style. 

No one is going to be able to mimic Warren's success exactly, but that doesn't mean you can't have success from value investing. Many investors who have copied Buffett's investing style have outperformed the S&P 500 by a huge margin

This strategy of investing will be extremely frustrating during a bull market. The stocks already considered too expensive for you will only continue to rise. The payback comes once the bull market ends and stocks come crashing down.

When everyone else is panicking and selling their stocks, you are gearing up to put all your money to work. However, your patience will pay off when you can find many good businesses you want to buy at great prices. 

Buying stocks at low prices is less risky than buying expensive stocks during a bull market because you are giving yourself a margin of safety

This results in a low-risk, high-reward strategy that will pay off greatly if you keep at it consistently. Finding stocks priced below their intrinsic value, holding them long-term, and selling once they return to or exceed their true value will result in great profits. 

This strategy does not provide instant gratification or make you rich quickly. If you want to succeed with this style of investing, you must be willing to wait a long time before you reap the rewards of your efforts. 

How to know if value investing is right for you

You want to become a value investor but aren't sure if it is the right strategy for you. If you are unsure if you should become a value investor or are even capable of it, ask yourself if you have the following criteria: 

  • Patience and diligence: Like all investment strategies, you must be patient and diligent enough to stick with your investment plan. You may want to buy stocks because they are fundamentally strong, but you'll have to wait if they are overpriced. 

You also may want to buy stocks that are attractively priced at the moment. These stocks can be tempting, but if they do not meet your criteria, you will have to continue to sit in cash and wait for another opportunity to arise. 

  • Strong critical thinking: You have to be able to think for yourself when the market is unanimously trending in one direction. Do not follow the herd. Always ask yourself if the price change of stock accurately reflects a change in intrinsic value. Usually, it doesn't. 
  • Willing to read a lot: You have to spend hours reading companies' financial statements and earnings reports. This is how a company is performing compared to its industry peers.

Annual reports also allow you to learn a lot about a company. They explain the company's products and services and where it is heading in the future. 

It is important to read these to fully understand companies and be able to predict the intrinsic value of companies accurately. 

  • Ability to ignore the market: Once you purchase a stock, selling may be tempting if the price falls. As a value investor, you cannot let emotions control your decisions. The easiest way to ignore your fear when the price falls is to ignore the market.

This does not mean ignoring the company you bought. Instead, continue to pay attention to the company's activities and financials to ensure the fundamentals are the same. As long as nothing changes fundamentally within the company, it would help if you didn't have to sell. 

  • Willing to stay in cash during bull markets: Value investing involves common sense and contrarian thinking. Most investors think sitting out of a bull market is crazy, but you have to be willing to go against the grain as a value investor. 

While you may miss out on some profits during a bull market, the superior compounding of your investments will compensate for the time you spent waiting in a cash position. 

If you are capable of all the criteria listed above, then value investing may be the best investment strategy for you

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Researched and Authored by Rohan Hirani | Linkedin

Uploaded and reviewed by Omair Reza Laskar | Linkedin

Edited and reviewed by Colt DiGiovanni | LinkedIn

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