Benjamin Graham, an American economist, investor, and professor, pioneered a new method of investing in stocks known as ‘Value Investing’ in the 1920s. He is known as the “Father of Value Investing”, and his methods ring true to investors till date, with notable followers such as Warren Buffet, Peter Lynch, etc. This ingenious approach to investment in securities allowed him to develop substantial wealth while minimising his risks by merely analysing companies with deft precision.
What is Value Investing?
It is an investment approach where investors seek out stocks of companies that are trading in the market at a price that does not agree with its intrinsic or inherent value. This method of investment requires a thorough understanding of the stock market.
In essence, value investing encapsulates two primary concepts – undervaluation and overvaluation. Value investors consider a stock to be undervalued when it is trading at a price lower than its intrinsic value. On the other hand, when a stock is trading at a price higher than its inherent value, investors consider such stock to be overvalued.
Value investors carry the belief that share prices do not justify the long-term fundamentals of a company because such prices are considerably dependent on market behaviour. They employ a contrarian investment approach by denying reacting as per market tendencies and, in most cases, moving in the opposite direction as the market.
How Does Value Investing Work?
The principle behind value investing is – purchase stocks when they are undervalued or on sale, and sell them when they reach their true or intrinsic value, or rise above it. Another condition which value investors follow is allowing for a margin of safety when trading in value investing stocks.
Stock prices can change owing to several reasons, underlined by a popularised market tendency which causes a share’s price to waver from its intrinsic value.
For instance, if as per popular market belief Company A will perform extremely well in the future, its share prices might increase from Rs. 100 to Rs. 120, further influencing the market into raising its demand and price dramatically from Rs. 120 to Rs. 180. However, upon inspection and proper analysis, it is found that the company has an average financial and organisational structure which does not withstand such high expectations. Thereby, its intrinsic value is determined at Rs. 80, which means it is overvalued by Rs. 100.
Top value investors refrain from partaking into such market tendencies and ferrets for stocks of companies that have sound long-term fundamentals. Still, due to several contributing factors, their prices are lower than their inherent value.
In other words, value investors seek companies with long-term potential but temporary downtrends in share prices due to market biases. Such investors analyse several parameters and bank on multiple financial metrics to determine which company is performing below its capacity in the market.
How do Investors Derive intrinsic Value?
When ferreting for value stocks, there are multiple fields which value investors look to cover to determine their intrinsic value as precisely as possible. These include a company’s financial history, its revenues and cash flows over the years, business model, profits, future profitability, et al.
They might also choose to investigate why stocks of a company are undervalued, and whether they have the necessary organisational and financial capacity to recover from such undervaluation.
There are also some qualitative indicators which provide an insight into whether stocks of a company are undervalued or overvalued. They are –
- Indulgence in a financial scam.
- The credit rating of a company signifying its debt clearing capacities.
- Profit or loss during the previous market recession.
In addition to this, a value investor also analyses multiple financial metrics to arrive at a more concrete conclusion regarding the underlying potential of a company, which are –
- Earnings Before Interests and Taxes (EBIT)
EBIT is used to determine a company’s cash flow without the effect of secondary expenses and profits. Taxation, here, is a primary factor as its laws allow for certain phenomena which might mask a company’s real earning potential.
For instance, a company might suffer losses in its initial years, but if it is founded on a sound financial and organisational framework, it shall generate profits in subsequent operating cycles. However, as tax laws dictate, companies can choose to carry forward their losses into following years to set off against future profits, causing such future profits to be lowered. It masks a company’s earning potential. Hence, taxation is left out to determine a company’s intrinsic value.
- Earnings Before Interests, Taxes, Depreciation, and Amortisation (EBTIDA)
It is a development on EBIT, whereby earnings are calculated after excluding depreciation and amortisation expenses. Depreciation and amortisation are provisions and do not affect actual cash flow. Therefore, it provides a more detailed and precise insight into a company’s earning potential.
- Discounted cash flow
Discounted cash flow analysis is a crucial metric which allows investors to devise a company’s future cash flows and find their current value. It does so with the use of a discounted rate accounting for price level increase. Investors use this metric to determine the present value of a company and its future potential.
As investors gain a concrete idea about the two factors mentioned above, they know whether its stocks are undervalued or not.
- P/E Ratio
Price-to-earnings ratio or P/E ratio signifies the relationship between a company’s share prices and per-share earnings (EPS).
If a company’s shares are priced at Rs. 100 in the stock market and its EPS is Rs. 18, its P/E ratio would be (100/18) or 5.55. This metric is crucial for every investor as it signifies the amount an investor needs to invest in a company to earn Re. 1 of its earnings. In the example provided here, an investor would need to pay Rs. 5.5/share to make Re. 1 of its earnings.
P/E ratio of a company goes up if its EPS is low and vice versa. When the P/E ratio of an organisation is high, it signifies that an investor needs to pay a large amount to earn one unit of the company’s earnings. Hence, a high ratio implies that the stock of such a company is overvalued.
- P/B ratio
P/B ratio or Price-to-book value ratio signifies the per unit book value of a company’s assets and per unit share price. For a company, the former is derived by dividing the total book value of a company’s assets by market value of its outstanding shares. In case a company’s share prices are lower than its per unit book value, it denotes that its stocks are undervalued. It also refers to the fact that an organisation possesses the necessary capacity to earn profits in the future and is facing a short-term financial crisis due to factors such as low demand.
Best value investors use these metrics and factors to determine whether a company qualifies as undervalued.
Advantages of Value Investing
- Risk minimisation
In general, investing in equity shares is associated with high risk due to its correspondence with market fluctuations. However, with value investing, investors mitigate that risk by earmarking stocks that are undervalued, and thus, can purchase potent shares on sale. Eventually, these shares would reach their intrinsic prices or maybe go higher, which would allow them to earn substantial capital gains.
Investors of this category use margin of safety to attenuate the associated risk. It means purchasing a share when its prices are lower than a particular limit. Thus, even if they are wrong about a specific company, losses, if any, would not be significant. Benjamin Graham, for instance, only purchased stocks when their prices were 2/3rd of the intrinsic value.
- Substantial returns
Value investing, if done accurately, can fetch above-average returns in the long-term. It is because investors employ a margin of safety, elaborated above.
For instance, if an investor purchases stocks of a company at Rs. 70/share when its intrinsic value is determined at Rs. 100/share, he/she stands to earn Rs. 30/share by selling it when the stock returns to its intrinsic value, and even higher if share prices go above its intrinsic value.
Disadvantages of Value Investing
- Long-term investment option
One of the primary disadvantages of value investing is that it does not provide higher returns in the short-run and thus compels investors to lock their capital for a considerable period.
Value investing online or offline consumes a significant amount of time as investors have to dedicatedly seek out companies that are undervalued by using several qualitative and quantitative fields.
Strategies for Value Investing
The key strategy to invest in undervalued stocks is by using the metrics mentioned above, such as EBDITA, EBIT, P/E ratio, etc. Investors who are willing to adopt value investing need to properly analyse a company and derive its intrinsic value to realise substantial profits and minimise risk.
An additional approach is seeking out companies that have assets which are not properly reflected in their balance sheet. Such assets include intellectual property like patents. Their value might increase in the future owing to market conditions, which causes stock prices to rise dramatically.
Difference between Value Investing and Growth Investing
|Value Investing||Growth Investing|
|Investing in companies that are undervalued in the stock market.||Investing in companies that have generated higher than average returns in current times.|
|Value stocks trade at a low or discounted price.||Growth stocks trade at a high price.|
|Low-level of risk.||High-level of risk.|