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Basics of Value Investing

Value investing is an investing style pioneered in the early 1920s at Columbia Business School by Benjamin Graham and David Dodd. Until then, stock market investing was driven mainly by speculation and insider information. Graham, who is known as the father of value investing, sums up the crux of value investing in his classic work The Intelligent Investor:

    An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

Graham began teaching his value investing approach at Columbia Business School in 1928. Two decades later, Warren Buffett enrolled for the course. He mastered the value investing approach and went on to become the richest investor ever. Here's what he says about value investing:

    The basic ideas of investing are to look at stocks as business, use the market's fluctuations to your advantage, and seek a margin of safety. That's what Ben Graham taught us. A hundred years from now they will still be the cornerstones of investing.

Buffett's glorious investing journey started from the basics of value investing.

We believe you too can start your investing journey here...from the very basics.

What is Value Investing?

Value investing is an investment approach that seeks to profit from identifying undervalued stocks. It is based on the idea that each stock has an intrinsic value, i.e. what it is truly worth.

Through fundamental analysis of a company, we can determine what this intrinsic value is. The idea in value investing is to buy stocks that trade at a significant discount to their intrinsic values (i.e. they are cheaper than their true value). Once we buy an undervalued stock, the stock price eventually rises towards its intrinsic value, and makes a profit for us in the process.

Value investing is conceptually simple, though requires effort to implement. Research process focuses on finding out the intrinsic value of a company and the primary tool for researching a company is called fundamental analysis.

Let us understand these bits of value investing more closely...

Four Pillars of Value Investing by Benjamin Graham

Benjamin Graham introduced four components that define the philosophy behind value investing.

Let us look at each one of them in detail...

  • Mr. Market

    Imagine you are in a partnership with Mr. Market, where you can buy or sell shares. Each day, Mr. Market offers you prices for shares depending on his mood. If Mr. Market is in a very optimistic mood, he will offer very high prices. In this case, an investor should cash out of shares. If Mr. Market is in a very pessimistic mood, he will offer low prices, and this is the time to buy.

  • Intrinsic Value

    Intrinsic value represents the true value of the company based on fundamentals. In the short term, market prices deviate from their intrinsic values due to changing market sentiments. In the long term, market prices return to intrinsic values. This process allows us to make profits, because we can buy stocks when they fall below their intrinsic values. We then hold them until they return to their intrinsic values in the long-term.

  • Margin of Safety

    The margin of safety is the essence of valuation. Since the estimates of intrinsic value involve subjective assessments, there is a possibility of being overly optimistic. Margin of safety provides cushion by adjusting the optimism from the forecast. Say, for example, your estimate of intrinsic value is Rs 100. Taking into consideration a margin of safety of 20%, you can adjust the value to Rs 80. This will ensure that you do not overpay for any asset.

  • Investment Horizon

    Value investing works in the long term, because that is when prices return to their intrinsic value. Value investing does not aim to predict what stock prices will do 2 days or 2 months from now. Instead, it aims to pick undervalued businesses that will outperform in the long term. This will eventually reflect in the stock price.

Evolution of Value Investing

Value investing started as a purely quantitative approach that has now evolved to incorporate a qualitative approach.

Benjamin Graham's view was that one only needed to look at the financial statements of a company in order to determine its value. There was no need to analyze qualitative factors such as a company's management, future product offerings, etc.

This approach is known as the cigar butt approach. The advantage of the quantitative approach is that it is based on hard facts alone. The analysis is objective, and less reliant on assumptions.

Unfortunately, the quantitative approach does not account for all the factors that determine a company's true value.

Qualitative factors such as the management quality, industry dynamics, competition, future products, consumer behavior, etc. are all relevant to a company's performance.

Warren Buffet's approach incorporated these qualitative factors into his analysis, along with the quantitative factors.

Let us know more about this approach to value investing by Warren Buffett...

Warren Buffet's Four Filter Approach to Value Investing

Warren Buffet's four filter approach is an evolved version to value investing. It is process by which one can arrive at an investment decision while keeping both, the qualitative as well as quantitative factors of value investing.

The approach identifies companies by going through the following four steps:

Step 1: Identifying Circle of Competence

This comprises of identifying all the businesses that you are familiar with and thoroughly understand.

For value investors, it is important to invest only in businesses that they understand. Value investors must focus solely on areas of business where they believe they have an edge over the average investor.

Likewise, staying away from what you don't understand is equally important.

Step 2: A Moat to Protect Your Castle

If we look at the castles, there is a deep moat all around. This moat was typically filled with water and crocodiles or other predatory reptiles to keep the attackers/enemies away. In value investing too, you should look to protect your castle.

In simple words, you should look for companies with a sustainable competitive advantage. Larger the advantage, wider is the moat. This moat would protect the business from competition.

And if the company is able to use its competitive advantage to widen the moat over time, then it is the perfect business to be in.

Companies that have a wide moat are able to earn higher returns for its shareholders. They are able to do so consistently year after year, every year. This in turn propels its projected stock value.

Step 3. Able and Trustworthy Management

Perhaps among the various factors that need to be looked at before investing in a company, the management is the most important.

Able and trustworthy management means that management consistently demonstrates competence and works in the interest of shareholders.

There are three main factors in assessing management:

  • The results of the company
  • The treatment of the company's shareholders
  • How well it allocates capital

Step 4. A Sensible Price Tag

Finally, a sensible price tag for stock selection is nothing more than having a margin of safety that we discussed earlier. It consists of valuing the company's true market value per share by various valuation methods.

Value Investing Valuation Methods

So, how can you determine the 'intrinsic value' of a stock?

In his 1992 letter to shareholders, Mr. Buffett has explained the concept of valuations in as easy a manner as possible.

Mr. Buffett seems to be a firm believer in using the 'discounted cash flow' (DCF) approach to valuations.

So, what is DCF and how does it work?

DCF is a valuation technique, the purpose of which is to arrive at future cash flows that a company is expected to generate over its lifetime and adjust it for time value of money.

The resultant value is nothing but the company's 'intrinsic value'.

Since different people will have different assumptions about a company's future cash flows, intrinsic value might vary from person to person.

This value is compared to the prevailing stock price to judge the investment worthiness of the stock.

If the intrinsic value is higher than the actual stock price of the company, then the stock offers an investment opportunity. The greater the discount to the intrinsic value, the more attractive the investment opportunity.

Conversely, if the intrinsic value is lower than the current market price, then the stock is 'over valued' and should be avoided.

Value Investing Ratios

There are also other stock specific valuation ratios you can use while selecting value investing stocks.

Two of these most common ratios are price to earnings ratio (PE ratio). The other is the price to book value ratio or (PB ratio).

  • Price to Earnings Ratio (PE Ratio)

    The price to earnings ratio (PE ratio) is the ratio of a company's stock price to the company's earnings per share. Find out how this ratio is calculated and how you can use it to evaluate a stock in this video:

  • Price to Book Value Ratio (PB Ratio)

    The price-to-book value ratio (PB ratio) is a ratio used to compare a stock's market value to its book value. Find out how this ratio is calculated and how you can use it to evaluate a stock in this video:

Value Investing Stock Screener

Now that you have read about value investing, here's the million-dollar question - Which Indian stocks match value investing stock picking criteria which stocks are the most undervalued?

Indeed, this is a difficult question to answer...but we are here to help you get started!

Find your answer right away with Equitymaster's Advanced Stock Screener.

Is Traditional Value Investing Dead?

Traditional value investing - the low price to book value or the low price to earnings ratio - has been getting a lot of bad press lately.

Growth investing has not just beaten the traditional value investing in recent years, it has blown it out of the water.

Joel Greenblatt, a very famous value investor, even shared the numbers in a recent interview.

As per his analysis, last five years, 'growth' - the way they define it for US stocks at firms like Morningstar or Russell - has outperformed 'value' (low price to book value or low price to earnings) by 11% per year.

In fact, Greenblatt isn't even sure whether value will make a comeback. As per him, it is quite possible the era of traditional value investing has come to an end for good.

Malti Gaonkar, a portfolio manager at US$ 20 bn Lone Pine Capital, agrees with Greenblatt.

Value isn't dead, it's just changed its name and appearance, she is believed to have said. The traditional hunting grounds of low PE stocks are a little dangerous, she added further.

Well, are these fund managers true in their assessment?

We believe these fears are overblown.

Most of the fund managers who think value investing is dead, have a very shallow understanding of the craft.

They believe that value investing is all about looking at past numbers and investing in a bucket of the cheapest firms by earnings or book value.

Well, Ben Graham would be furious at this interpretation of value investing. To invest only on the basis of past numbers is pure speculation as per him.

Benjamin Graham has also been quite explicit about allowing qualitative factors like earnings stability and future prospects to play an important role in stock analysis. Therefore, those who think of Graham as a 'quant' who relied only on undervaluation, are misinformed.

However, what Graham was strictly against was using qualitative factors that are way out of line of its historical performance, to justify an investment in a stock.

For e.g. if a company has grown its earnings at 12% historically and the analyst is assuming it to grow at 25%, it was something that was hard for Graham to digest.

Another example would be giving the company a slightly higher price to earnings (PE) multiple for expected stability in earnings when its history has been particularly volatile.

Graham believed, and rightly so, that these investments are not based on sound logic.

Thus, as long as the conclusions rest on figures and upon established tests and standards, the above traditional approach to value investing will flourish.

We don't see any reason as to why this type of investing will ever go out of fashion. It will continue to give great results for those who choose to follow it with discipline and patience.

Value Vs Growth Investing: The Winner Is...

The Sensex is trading at a price to earnings multiple of nearly 30 times, a valuation that would make conventional value investors shake their heads in disgust.

If you go by the media reports, value is out of favour, with more fund managers shifting to growth camp.

The video below shares the fallacies in this broad and sweeping narrative...and an interesting approach to playing the markets for healthy returns.

So these are the steps on how to go about value investing and make big money in the stock markets.

Happy investing!

FAQs on Basics of Value Investing

1. What is Value Investing?

Value investing is a style of investing based on estimating the intrinsic or true value of a business and buying its stock for less than that value.

They calculate a company's intrinsic value with in-depth financial analysis.

The idea is to buy a stock with a 'margin of safety' in terms of valuations i.e. buying a stock for less than what it should be worth.

To know more about the concept of margin of safety watch this video by Rahul Shah, Equitymaster's co-head of research - The 3-Word Secret to Earning Incredible Returns.

The same idea holds true in reverse when selling a stock. Value investors sell when they think the stock price is above what it should be worth i.e. there is no margin of safety.

In other words, when value investors make their buy and sell decisions they disagree with the market's assessment of the stock in question.

Value investors are contrarian by nature. They don't follow the crowd. They tend to buy when everyone else is selling and sell when everyone else is buying.

They are active buyers during market crashes and bear markets. They are active sellers during phases of high momentum and bull markets.

You can get started with value investing by reading Equitymaster's detailed article on the Basics of Value Investing.

2. What is the Value Investing formula?

The basic idea behind value investing is to 'buy low, sell high'.

This means buying a stock when it is trading cheap relative to its assets, earnings, and cash flow.

The value investor sells the stock after it has risen to a level that makes it expensive relative to its assets, earnings, and cash flow.

To do this value investors use the following metrics.

We suggest using Equitymaster's Value Investing Stock Screener to quickly and easily find stocks based on these metrics.

3. What is the Value investing strategy?

Value investors use tools like price to earnings (PE), price to book value (PB), dividend yield, etc to invest in fundamentally strong companies.

They first study the company's past financials going back many years. They arrive at a reasonable estimates for future growth as well as the risk factors.

They use this knowledge to make a reasonable future projection of the company's earnings. They compare this projected value with the company's current valuation.

If the margin of safety is high enough, they buy. They repeat this process regularly as new information about the business is available.

If the stock price rises far above the future earnings estimates, they sell.

4. Who is the best Value Investor?

Warren Buffett is widely regarded as the best value investor in the world.

To read all about the 'Oracle of Omaha' please click here.

To find Buffett-like stocks in India, use Equitymaster's Warren Buffett stock screener.

Here are Links to Some Very Insightful Equitymaster Articles and Videos on Value Investing...

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