By Adriano Mesina
Warren Buffet, a legend in value investing, once told shareholders of Berkshire Hathaway that there is a redundancy in the term value investing. After all, the purpose of investing is to find value for the amount of money we pay, Buffet said.
Various sources explain value investing quite differently. A few say value investing is the investment ideology that encourages the acquisition of stocks that are presently trading at low price-to-book ratios and have high dividend earnings. Others define value investing as being all about taking stock with low price to equity ratios. Some versions say value investing is more about the balance sheet than the income statement.
What is value investing?
Whether or not the term value investing is appropriate, it is here to stay and is already universally used. Generally, it refers to the purchase of stocks that have characteristics like a low price to earnings ratio, low price to book value ratio or a high dividend yield.
Unfortunately, such attributes are far from conclusive as to whether an investor is truly purchasing something for what it is worth. It also does not mean it is working based on securing value in investments.
At the same time, contradicting characteristics such as high price to earnings ratio, high ratio of price to book value, and low dividend yield, are not in any way inconsistent with a value purchase.
We can then say that Warren Buffet’s definition of value investing is on point. It is truly the act of buying a stock at a price below its calculated value.
Principles of value investing
1. Each share of stock is an ownership stake in the primary business.
A stock is not just a piece of paper that owners sell at a higher price on some future date. Stocks are more than just the right to collect future cash distributions from a company. Each share is an undivided interest in all its resources – both tangible and intangible – and should be valued as such.
2. A stock has an underlying value.
A stock’s inherent value is taken from the economic value of the underlying company.
3. The stock market is faulty.
Unlike most investors, value investors believe that the market is inefficient. In other words, they do not follow the herd. They believe shares usually exchange hands at prices above or below their underlying values. Periodically, the disparity between the market price of a share and the intrinsic value of that share is large enough to enable lucrative investments.
4. Investing works best when it is business-like.
Investors should approach investing with the same earnestness and studiousness they treat their profession. An investor should deal with the shares he or she purchases and sells them just as an entrepreneur would care for the merchandise they sell. He or she must not make promises where the grasp of the merchandise is deficient. Additionally, he or she must not undertake any investment activity unless a reliable computation indicates that it has a reasonable chance to bring in an acceptable profit.
5. A smart investor demands a margin of safety.
A firm’s working capital position, past earnings, economic goodwill, land assets, or a mix of some or all of the above, can provide a margin of safety. We can illustrate the margin of safety via the difference between the quoted price and the underlying value of the firm. It takes in all the damage caused by the investors’ blunders if any. That is why the margin of safety needs to be as vast as investors are irrational.
Metrics used in value investing explained
1. Price-to-book
Also known as book value, it measures the value of a firm’s assets and compares it to the stock price. If the company is not in financial hardships, a lower stock price means the stock is undervalued.
2. Price-to-earnings
It shows the business’ history for earnings. It is important because here you can find out if the stock price is undervalued or does not reflect all earnings.
3. Free cash flow
Free cash flow is the cash generated from a business’ income after we deduct the expenses. It is the remaining cash after the expenses are paid. If a business has a healthy cash flow, it will have adequate funds to invest in its future, pay off debts, distribute dividends, and issue share buybacks.
By far, these are not the only metrics that investors can use in evaluating a company. You can analyze sales, equity, debt, revenue growth, and others. But these metrics, as a starting point, can help the value investor decide if the stock is attractive enough.
What value investing is not
Value investing is the attempt to acquire stock for a price that is less than its determined value. While it sounds like it is the most logical way to invest, this fact alone differentiates value investing from most other investment protocols.
Growth investors concentrate only on the value of the company. The price paid does not matter to them since the only important thing is to acquire shares in extraordinary businesses. Growth investors think that the remarkable growth such businesses will experience over a great many years will let them benefit from the marvels of compounding. Even if the price is too high, as long as the value of the business compounds fast enough and the stock is held long enough, the high price is justified.
Some individuals who call themselves value investors do look at relative prices. They decide based on how the market values public companies in the same sector. They may elect to invest in a stock just because it comes up cheap relative to its rivals. However, this method cannot be classified as true value investing.
Investment approaches supported primarily on an empirical basis are not part of value investing because it needs the computation of an intrinsic value that is not dependent on the market price.
Factors that drag a stock’s value down
1. Herd mentality
Investors can become irrational and invest based on psychological biases instead of market fundamentals. FOMO, or fear of missing out, is such a powerful emotion, which is to the detriment of investors.
Such behavior affects the value of stocks – aggravating upward and downward market movements – thus creating excessive moves.
2. Market crashes
Historically, when the market reaches incredible highs, it results in a bubble. The high level is not sustainable. As a result, investors panic and this causes massive selloffs leading to a market crash.
3. Cyclicalities
These are fluctuations that affect companies. Businesses are vulnerable to ups and downs in the economic cycle. It can make an impact on profit levels and the price of a company’s stock. However, it does not affect the value of the company in the long term.
Value investing strategies
1. Do your research
Understand the company you want to invest in before purchasing stock. Know what its long-term plans are, its business principles, financial structure, and of course, its management team. Smart investors would rather look at the jockey instead of the horse, so to speak.
Value investors want companies that distribute dividends consistently.
2. Diversify
Diversification is a strategy employed by smart investors. When you diversify, you minimize your risks and at the same time, raise your chances of earning a profit on some of your investments.
3. Seek consistent and safe returns
Sure, it is nice to get rich overnight, but even the lottery only gives you a 1 in 292 million chance to win. It would be much better if you look for a stock that can give you a safe and steady return.
Conclusion
Ultimately, we define value investing as paying less for a stock than its assumed value, where the system used to calculate the value of the stock is independent of the stock market.
Many investors have built up their wealth considerably using a value-based technique to investing. These investors include greats like Warren Buffet, Benjamin Graham, Charlie Munger, and Seth Klarman. This analysis of value investing indicates a system that works well over time if you purchase correctly and are patient enough to hold for the long term.