Since the creation of the first stock exchange and financial markets, financial operators have developed many different approaches to investing, based on principles or ideas that most of the time proved to be not very reliable and effective.
However, a few of these approaches and strategies proved themselves to be not only interesting but also effective, and therefore they have been adopted by some of the most relevant players in this sector.
In fact, investors were able to adapt these strategies to their ideas, thus creating strategies which may be considered as variations of a basic idea, but that keep that original idea as a paradigm, and as the foundation of their approach to investing.
One of these strategies, and probably the most famous of all in the world of investing and personal finance is value investing.
Value investing is an investment strategy that involves buying securities or assets in general, that result as underpriced by some form of fundamental analysis, and that therefore appear to be trading below their intrinsic value.
As said before, there are different forms of value investing, different approaches to it, but they all come from the investing philosophy fist taught, at Columbia Business School, by Benjamin Graham and David Dodd. They developed and diffused their strategy in the book Security Analysis, published in 1934.
In particular, Benjamin Graham is considered the “father” of value investing but it is interesting to note that he never named his strategy, “value investing”. The term was coined later to help describe his ideas.
The ideas of Graham and Dodd have inspired many of the greatest investors of all time, like the billionaire Warren Buffet, who is considered the best investor of all time. Buffet worked for Graham in his partnership at the beginning of his career, which continued brilliantly, bringing him to build a net worth of more than $88 B.
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How does it work?
“Price is what you pay, value is what you get.” Warren Buffett
This famous quote by Warren Buffett tells a lot about the idea behind value investing.
In fact, it is based on finding the “value” of the company we are looking at and investing in those stocks that are trading at a price that is sufficiently lower than its value.
Value investors constantly look for stocks that they think are currently being underestimated by the market. They do it because the stock market usually tends to overreact to good and bad news, resulting in stock price movements that do not correspond to a company’s long-term fundamentals or fair value.
The overreaction offers many opportunities to profit by buying stocks at discounted prices, like goods on sale.
Value investors use the same basic principles like if they were going to buy goods at the supermarket, it makes no sense to buy a product paying the full price while you know that some times a year it goes on sale.
In return for buying and holding these value stocks for the long-term, value investors can obtain very good and solid returns.
How to find intrinsic value?
Finding the intrinsic value of a company is not an easy task, in fact, it does not exist one only way to do it. Stock analysis is not an exact science, it is more as an art form.
There are many different values to look at and different types of analysis that can be made. In my opinion, it is better to use different measures, and ratios to have a set of values to look at, not a single one, and it is also important to consider having a “margin of safety”, another concept introduced by Munger and Dodd.
Having a margin of safety means buying a stock at a price that is sufficiently lower than its intrinsic value so that even if our analysis results not so precise, we can still make a profit.
However, as said before, there are different methods to analyze and determine the intrinsic value of a company, in the following section I will list some of the main measures to look at while trying to determine if a company is currently overvalued or undervalued:
- Price to Earnings ratio (P/E): is the ratio for valuing a company that measures its current share price relative to its per-share earnings. It shows the company’s track record for earnings to determine if the stock price is not reflecting all of the earnings or undervalued.
- Price to Book ratio (P/B): measures the value of a company’s assets and compares them to the stock price. If the price is lower than the value of the assets, the stock can be considered undervalued.
- Free Cash Flow (FCF): The cash remaining after expenses have been paid, is the cash generated from a company’s revenue or operations after the costs of expenditures have been subtracted. If a company is generating free cash flow, it’ll have money left over to invest in the future of the business, pay off debt, or pay dividends to shareholders.
As you may have noticed, value investing does not consist of a rigid set of steps to follow, it is more a set of principles that are taken as the foundation of many investing strategies.
At its core it is based on the idea that markets are not efficient, at least in the short-term, in fact, value investors try to take advantage of market inefficiencies that appear in the short-term, expecting that in the long run, the stock market will “understand” the real value of the stock.
This is how value investors can make good and consistent returns over time.