Stock Investing: A Guide to Value Investing

What is Stock Investing?

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 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 companies' financial statements to determine their intrinsic values and compare those with their trading prices. 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. 

The Basics of Traditional Value Investing

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 Number

Graham created his alternative valuation metric known as the Graham number. The concept behind the Graham Number is to identify stocks that are trading below their intrinsic value.

Benjamin Graham believed that investors should seek out stocks trading at a significant discount to their intrinsic value to achieve superior returns with lower risk.

The formula for calculating the graham number is: 

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. 

New Price-Earnings Ratio

A "New Price-Earnings Ratio" is the term used by Benjamin Graham to describe his adjustment of the conventional price-earnings ratio (P/E ratio) to take inflation into consideration.

Graham contended that conventional P/E ratios, which failed to account for the depreciation of purchasing power, may be deceptive in periods of elevated inflation.

Graham proposed dividing the earnings yield by the total of the current rate of inflation plus a constant in order to modify the P/E ratio.

The formula for Graham's modified P/E ratio is:

Modified P/E Ratio = Earnings Yield / (Base Interest Rate + Expected Growth Rate)

In this case, the P/E ratio is inversed by the earnings yield (1/P/E ratio). The yield on high-grade corporate bonds, usually the yield on long-term AAA-rated corporate bonds, is represented by the base interest rate.

The projected growth rate estimates the company's future earnings growth rate. By modifying the P/E ratio in this way, Graham intended to give a more accurate evaluation of a stock's valuation during times of strong inflation.

Graham’s Basic Value Investing Approach

Buying stocks that are trading below their inherent worth is the cornerstone of Benjamin Graham's value investing strategy. This strategy prioritizes a long-term outlook and a margin of safety.

Graham was an advocate of not depending only on market emotion or short-term changes but also on basic considerations such as book value, dividends, and earnings when analyzing companies.

Key principles of Graham's value investing approach include:

1. The Margin of Safety: Invest in equities to protect yourself against future losses when they are selling at a substantial discount to their intrinsic worth.
2. Fundamental Analysis: To determine a company's actual value, concentrate on examining its financial records, earnings, dividends, book value, and other essential components.
3. Diversification: To lower risk, diversify your investments by holding a variety of stocks.
4. Long-Term View: Ignore short-term market swings and instead invest with an eye towards the long term.
5. Emotional Discipline: Keep a logical, disciplined attitude to investing and resist the urge to be influenced by market mood or noise.

Many investors throughout the years have benefited greatly from Graham's value investing philosophy, notably Warren Buffett, who is perhaps his most well-known student.

It highlights a methodical and disciplined approach to investing that is grounded in in-depth research and prioritizes intrinsic value over market movements.

Determining the value of stock

Value investors continue to pay attention to Graham’s valuation methods, but we have also 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. It is one of the few metrics that 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 = FV/ (1 + r)ⁿ

• 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 projecting future cash flows. A reverse DCF starts with the current share price and 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 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. 

Stock investing Strategies

Like every type of investment, strategies for value investing differ among individuals. However, some generally accepted principles are 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: 

1. Buying businesses, not stocks

This means that you should ignore stock price trends 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 market tracking, and value investors would rather spend their time searching for good businesses selling at good prices. 

2. Passion for the businesses you invest in

This implies investing solely in businesses you thoroughly understand and are genuinely passionate about. Delve beyond basic P/E and P/B ratios into the company's financials to grasp its underlying dynamics.

3. Invest in businesses you comprehend

This is a fundamental rule for value investors. Given that this investing style involves forecasting future earnings, it's imperative to understand the business thoroughly to make informed projections.

4. Finding well-managed companies 

It 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 look for management with integrity, intelligence, and energy.

5. Tune out market noise

This 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 Stock 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 Stock 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: 

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

2. 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.

3. 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. 

4. 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.

5. 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. 

Conclusion

Value investing, popularized by investment icons such as Warren Buffett and Benjamin Graham, is a methodical way to build wealth. It involves choosing stocks carefully and using fundamental analysis as a guide.

Value investors can generate wealth over time by concentrating on discounted companies with solid fundamentals, even in the face of market volatility.

Value investing can yield significant returns for those who follow its guidelines, even though it requires perseverance, diligence, and the capacity to tolerate market volatility.

If you are patient, have a critical mind, do thorough research, and have a contrarian perspective, value investing can be the best way for you to reach your financial objectives.

Free Resources

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