Meta: Learn about value investing and how it can help investors find discounted stocks through fundamental analysis.
Value investing is an investment paradigm introduced by Benjamin Graham and David Dodd in the 1920s. Through the years, well-known investors such as Warren Buffett, Charlie Munger, Dr. Michael Burry, and many more have modified and improved value investing.
While the investors mentioned above have used value investing, you may be wondering what value investing really is.
Value investing focuses on buying assets that seem to be trading for less than their worth. Through this method, investors are able to determine the intrinsic value of an investment, and learn to wait until they can buy the assets for prices lower than their underlying value.
Value Investing Explained
Value investing is simply buying stocks at a discount. It is an investment strategy where you, the investor, find and go for undervalued stocks. In other words, you’re after companies currently priced below their intrinsic or true value.
Intrinsic value represents a firm’s or asset’s perceived value based on its cash flows. With market value, you see the price other investors are willing to pay for the investment. Intrinsic value, on the other hand, lets you know the investment’s value based on fundamental analysis.
You can determine the true value by examining the company’s financial statements, i.e., fundamental analysis. Intrinsic values are usually presented as a range instead of an exact number because of the assumptions taken into account when calculating the value of a complex organization.
While that is the case, it shouldn’t pose a problem for investors. Rather, they may prefer securities worth as much as or less than their intrinsic values.
Still, value investing should be done wisely and based on in-depth research and analysis. Value investing aims to help investors avoid losses and allow them to turn a profit rather than choosing risky securities with a low potential to generate profits.
With those things considered, we can say that value investing is qualitative, calculative, and quite predictive, but speculative is not one of its defining features.
Calculating Intrinsic Value
Calculating a company’s intrinsic value will help you determine the current value of all the company’s expected future cash flows. The process involves getting an estimate of future cash flows and the interest rate that would be used to calculate the present value of each of those future cash flows.
Those assumptions are why intrinsic value typically doesn’t have a specific number but is instead presented as a range.
Berkshire Hathaway Inc. Chief Executive Warren Buffett has described intrinsic value as the ‘only logical approach’ to assessing an investment’s and company’s relative attractiveness.
According to him, intrinsic refers to the discounted value of the cash that can be withdrawn from the business during the remainder of its life.
Some investors use several metrics to see whether an asset is trading for less than its intrinsic value. It’s good to start with these metrics, but you should still have some plan on how you’re going to use them.
Calculating Intrinsic Value: Price-to-Book (P/B) Ratio
Price-to-Book (P/B) ratio helps companies draw a comparison between their market value and book value. Usually, the market’s valuation of the firm is higher than its book value.
The P/B ratio can be determined by dividing the company’s stock price by its book value per share (BVPS).
BVPS represents the firm’s net worth (total assets minus total liabilities) divided by the number of shares outstanding. When calculating the P/B ratio, investors sometimes take tangible assets, such as goodwill, out of the equation.
Theoretically, a stock with a P/B ratio under 1 suggests it is selling below the company’s net asset value. A few banks today are trading for less than their book value, while the market prices of some growth companies are above their net worth.
Still, note that there is no P/B ratio that can precisely define value against growth securities. P/B ratios change all through the business cycle. If stock prices rise, so is the P/B ratio, and vice versa.
Calculating Intrinsic Value: Price-to-Earnings (P/E) Ratio
Price-to-Earnings (P/E) ratio compares the company’s stock price per share to its earnings per share. For example, a P/E ratio of 10 could mean that it will take ten years at the firm’s current earnings before it can be the same as the cost of the share.
A company might be a value stock if it has a lower P/E ratio. No specific level determines whether a stock is a value investment, although the P/E ratio should be below the average P/E ratio of the market overall.
Like the P/B ratio, a low P/E ratio doesn’t automatically mean you should go for the company. Instead, these two ratios are more geared toward helping you start your analysis in the right direction.
Choosing Stocks with Another Method Besides Value Investing
Value investing is not the only sound investment method available you can use to find stocks that could be worth your money. Growth investing offers an alternative to value investing. In growth investing, you choose companies that are increasing more quickly than other firms.
Unlike value investing, where a low P/B or P/E ratio is an important indication, growth investing focuses on the growth rate of the company’s revenue and profits. Additionally, growth companies’ P/B and P/E ratios tend to be very high.
Value and growth investing can bear average market returns over time. For some years, growth investing has fared better than value investing in the current market. However, in the past, value investing was able to outperform growth investing for a pretty long time.
Still, avoid assuming that investors prefer growth investing over value investing. These two will both have their turn at the top.
Value and growth investing are not the only approach to stock selection, although other methods do not involve using fundamental analysis.
For example, investors who use technical analysis rely on historical market data to make a forecast of upcoming market prices. Similarly, day traders assess short-term fluctuations in the market instead of the intrinsic value.
There are many ways to determine the intrinsic value of an investment, but what’s important to remember is that value investors don’t rely on market prices alone when deciding. Instead, calculating the intrinsic value is a crucial requirement for them.