What is Value Investing?
By Nathan on The Capital
Value Investing, you hear about it on t.v, online and in books but what exactly is Value Investing?
Value Investing was made popular by Benjamin Graham, the author of the investing classic The Intelligent Investor.
Value Investing involves buying an asset for less than what it is worth. If you know a company is worth $100 per share then you will try and buy it for $50. This leaves you with potentially $50 in profit.
It makes perfectly, simple sense. The difficulty lies in working out how much a company is worth.
Who are some famous Value Investors?
Warren Buffett
Warren Buffett is the most well-known investor today and he is a value investor.
Buffett is the CEO and chairman of Berkshire Hathaway. He sits at number 3 on the Forbes rich list behind Bill Gates and Jeff Bezos.
Investing through Berkshire Hathaway, Buffett has achieved a 20.9% annual return from 1965 to 2017 according to CNBC. This is more than double the 9.9% annual return of the S&P 500. Buffett learned his investment strategy from his mentor and college professor Benjamin Graham.
Benjamin Graham
Graham is known as the Father of Value Investing. He is the author of the investing classic The Intelligent Investor.
Read my summary and review of The Intelligent Investor.
According to investopedia.com, Graham achieved an annual return of around 20% for his investing career. He is best known for his two key concepts to investing known as The Margin of Safety and Mr Market.
Some other successful Value Investors you may have heard of include David Dodd, Charlie Munger, and Seth Klarman.
If you would like to read about these investors' strategies and others check out my Investor Strategies section.
How Value Investing Works
The concept behind value investing is simple. If you know how much something is worth and you buy it for less than that you are getting a bargain.
If you know a car is worth $10,000 and you see it advertised for $5,000 it is easy to see how that is a great deal.
You could potentially buy that car than go and sell it to someone else for $10,000.
Stocks work the same way. If you know a stock is worth $100 per share and it is selling for only $50 it is a great buy.
You could then hold on to that stock until the stock returns to its value of $100 per share and sell it to someone else.
How Much is a Stock Worth?
The hardest part of Value Investing is determining how much a stock is worth. Once you determine how much a stock is worth you can simply buy it for less than that and sell it for more.
But how do we know how much a stock is worth? To find out how much a stock is worth we have to find something called Intrinsic Value. Intrinsic Value is the company’s true value, just because a stock has a price of $50 per share doesn’t mean that its intrinsic value is $50 per share. Warren Buffett says -
“price does not equal value”
There are many ways to calculate intrinsic value but they all essentially do the same thing. My favourite way to calculate intrinsic value using the discounted cash flow method but there are other ways such as the:
- Dividend Discount Model
- Residual Income Model
- Gordon Growth Model
If you would like to learn how to calculate intrinsic value check out my free course - How to Find Intrinsic Value (coming soon).
Other ways to find Value
The methods of finding intrinsic value above will help you to find the Absolute Value of a company. After using one of the above methods you will end up with a dollar value for the company.
Another way to determine value is through Relative Value.
Relative Value is when you compare one company to another with metrics or ratios.
The most common ratios used are:
- The Price to Earnings Ratio (PE)
- The Price to Book Ratio (PB)
The Price to Earnings Ratio (PE)
PE stands for Price to Earnings. To find the PE for a company we divide its price by its Earnings per Share (EPS)
PE = Price / EPS
The PE ratio can be used to compare companies in the same industry, such as two companies that manufacture TVs. The general rule is the lower the PE ratio the cheaper the stock. The exception to the rule is for cyclical companies such as the automotive industry.
To learn more about the PE Ratio read — What is the PE Ratio?
The Price to Book Ratio (PB)
Another Method is the Price to Book Ratio or PB.
Price to Book Ratio = Price / Book Value
Book value is the value of the companies equity per share.
Equity is the value of all the companies assets minus the value of all their liabilities.
If a stock has a PB of 1 it means that you are paying $1 for each $1 of book value.
If a company has a PB of 2 it means you are paying $2 for each $1 of book value.
A company with a PB of 1 is cheaper than a company with a PB of 2.
If you want to learn more about the Price to Book Ratio read — What is the Price to Book Ratio?
Why Value Investing Works
So we have discussed what Value Investing is, who uses it and how you can do it, but you are probably wondering why it actually works.
The truth is Value Investing works because markets are not efficient. There are many out there who believe in something called the efficient market hypothesis.
The Efficient market hypothesis
The efficient market hypothesis says that because there are so many people out there who all have access to the same information that all stocks must always be valued correctly.
While markets may be efficient a lot of the time, it does not mean they are efficient all the time. All you have to do is look at the price of a company after a news release. Stock could be trading for $10 today, tomorrow a bad news story breaks and its investors panic and sell the stock down 30% to $7.
As a value investor, you see the price has fallen 30% so you buy. A week later the panic has settled, people are acting rationally again and the price has rebounded to $10. This is when you can sell and cash in.
Markets are not efficient because people are not rational. When things go wrong we panic and oversell causing prices to go down more than they should.
When things are going well we get a boost of confidence and overbuy causing prices to go up more than they should.
Value Investors aim to take advantage of these variances between price and value.
Key Points
- Value Investing is an investing strategy where you aim to buy a stock for less than what they are worth
- The most famous investor in the world, Warren Buffett is a Value Investor.
- To be a value investor you need to be able to calculate the intrinsic value of a stock.
- Intrinsic value can be calculated using Absolute and Relative methods
- Absolute methods include the Discounted Cash Flow Method and the Dividend Discount Model
- Relative methods include the PE ratio and the Price to Book Ratio
- Value Investing works because humans are irrational, which makes the market inefficient.
Resources referenced
Free Course: How to Find Intrinsic Value. (Coming Soon)
