What Is Value Investing?
Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. The overreaction offers an opportunity to profit by buying stocks at discounted prices—on sale.
Warren Buffett is probably the best-known value investor today, but there are many others, including Benjamin Graham (Buffett's professor and mentor), David Dodd, Charlie Munger, Christopher Browne (another Graham student), and billionaire hedge-fund manager, Seth Klarman.
How Value Investing Works ?
The basic concept behind everyday value investing is straightforward: If you know the true value of something, you can save a lot of money when you buy it on sale. Most folks would agree that whether you buy a new TV on sale, or at full price, you’re getting the same TV with the same screen size and picture quality.
Stocks work in a similar manner, meaning the company’s stock price can change even when the company’s value or valuation has remained the same. Stocks, like TVs, go through periods of higher and lower demand leading to price fluctuations—but that doesn't change what you’re getting for your money.
Just like savvy shoppers would argue that it makes no sense to pay full price for a TV since TVs go on sale several times a year, savvy value investors believe stocks work the same way. Of course, unlike TVs, stocks won't go on sale at predictable times of the year such as Black Friday, and their sale prices won’t be advertised.
Value investing is the process of doing detective work to find these secret sales on stocks and buying them at a discount compared to how the market values them. In return for buying and holding these value stocks for the long term, investors can be rewarded handsomely.
What is intrinsic value & value investing ?
Intrinsic value is a core concept that value investors use to uncover hidden investment opportunities. In options trading, intrinsic value is the difference between the current price of an asset and the strike price of the option. When an asset's market price is below its intrinsic value, it may be a smart investment.
Value investing is the art of buying stocks which trade at a significant discount to their intrinsic value. Value investors achieve this by looking for companies on cheap valuation metrics, typically low multiples of their profits or assets, for reasons which are not justified over the longer term.
What is the Margin of Safety in Value Investing ?
Margin of safety is a principle of investing in which an investor only purchases securities when their market price is significantly below their intrinsic value. In other words, when the market price of a security is significantly below your estimation of its intrinsic value, the difference is the margin of safety.
The value represented by your margin of safety is your buffer against becoming unprofitable. In the real world, the minimum margin of safety percentage to aim for generally depends on your cost structure.
If your costs are largely variable, then a margin of safety percentage of 20%–25% may be acceptable.
The margin of safety also makes you less likely to lose money if the stock doesn’t perform as you had expected.
The key to buying an undervalued stock is to thoroughly research the company and make common-sense decisions. Value investor Christopher H. Browne recommends asking if a company is likely to increase its revenue via the following methods:
Raising prices on products
Increasing sales figures
Decreasing expenses
Selling off or closing down unprofitable divisions
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There are no quantitative software programs yet available to help achieve these answers, which makes value stock investing somewhat of a grand guessing game.
For this reason, Warren Buffett recommends investing only in industries you have personally worked in, or whose consumer goods you are familiar with, like cars, clothes, appliances, and food.
Value Investing Requires Diligence?
Estimating the true intrinsic value of a stock involves some financial analysis but also involves a fair amount of subjectivity—meaning at times, it can be more of an art than a science.
Diligence falls into three main categories: legal due diligence. financial due diligence. commercial due diligence.
Diligence is defined as an investigation of a potential investment (such as a stock) or product to confirm all facts. These facts can include such items as reviewing all financial records, past company performance, plus anything else deemed material.
Some investors, who look only at existing financials, don't put much faith in estimating future growth. Other value investors focus primarily on a company's future growth potential and estimated cash flows. And some do both: Noted value investment gurus Warren Buffett and Peter Lynch, who ran Fidelity Investment's Magellan Fund for several years are both known for analyzing financial statements and looking at valuation multiples, in order to identify cases where the market has mispriced stocks.
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Value Investing Risks ?
Overpaying for a stock is one of the main risks for value investors. You can risk losing part or all of your money if you overpay. The same goes if you buy a stock close to its fair market value. Buying a stock that's undervalued means your risk of losing money is reduced, even when the company doesn't do well.
Here are three main risks for value investors
Falling into ‘value traps’
Mis-assessing cash flows and margin of safety
Ignoring Ratio Analysis Flaws
Falling into ‘value traps’
A value trap is a stock or other investment that appears to be cheaply priced because it has been trading at low valuation metrics, such as multiples in terms of price to earnings (P/E), price to cash flow (P/CF), or price to book value (P/B) for an extended time period.
2. Mis-assessing cash flows and margin of safety -
From an investment standpoint, margin of safety is a purchase made when the market price is well below its intrinsic value, or its true worth. The difference between the purchase price and the intrinsic value, is known as the margin of
safety. Knowing the difference helps an investor to make a purchase with the least amount of risk.
3. Ignoring Ratio Analysis Flaws -
Earlier sections of this tutorial have discussed the calculation of various financial ratios that help investors diagnose a company’s financial health. There isn't just one way to determine financial ratios, which can be fairly problematic. The following can affect how the ratios can be interpreted:
* Ratios can be determined using before-tax or after-tax numbers.
* Some ratios don't give accurate results but lead to estimations.
* Depending on how the term earnings are defined, a company's earnings per share (EPS) may differ.
* Comparing different companies by their ratios—even if the ratios are the same—may be difficult since companies have different accounting practices.
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