Value Investing is the strategy of choosing shares that are trading at less than their intrinsic value. In other words, Value Investors look for stocks they believe have been undervalued by the market.
They believe the market overreacts to both positive and negative news, resulting in stock price movements that do not correspond with the company’s long-term fundamentals. The result is an opportunity for Value Investors to profit by buying when the share price is low.
Estimating intrinsic value
The central problem for Value Investing is how to estimate intrinsic value as there is no universally accepted way to obtain this figure.
Most often intrinsic worth is estimated by analysing a company’s fundamentals, particularly their financial statements. Look in particular at its debt ratios (debt levels should be low) and look for good cash flow. A company with manageable debt and good cash flow is worth getting to know better, regardless of how the market is treating the share price.
Some Value Investors only look at present assets/earnings and don’t place any value on future growth. Other Value Investors base strategies on the estimation of future growth and cash flows.
Despite the different viewpoints Value Investing means buying stock at a price less than its inherent worth. Value Investors thus select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.
Margin of safety
A crucial aspect of Value Investing is “margin of safety”. This just means that you buy at a big enough discount to allow some room for error in your estimation of value.
What does a Value Investor look for in a stock?
The Value Investor looks for stocks with strong fundamentals – including earnings, dividends, book value, and cash flow – that are selling at a bargain price, given their quality.
The Value Investor seeks companies that seem to be incorrectly valued (i.e. undervalued) by the market and therefore have the potential to increase in share price when the market corrects its error in valuation.
Value Investors look for value
Value Investing doesn’t mean just buying shares in a company where the price is declining and therefore seems “cheap” in price. Value Investors must research the company thoroughly and must be confident that the share is undervalued for some reason. It is therefore only ?cheap? in relation to its inherent value, or worth.
It’s important to distinguish the difference between a value company and a company that simply has a declining price. For example, if a company’s shares have been trading at about $35 for a year, but suddenly drop to $15 per share, it does not automatically mean that the share is a bargain. All you know at this stage is that the company’s shares are trading at a much lower price than a year ago.
This drop could be attributable to the market reacting to good or bad news (such as the appointment of a new CEO), or it could reflect a fundamental problem in the company.
To be a real bargain, this company must have healthy fundamentals and its inherent value must be more than $15. Value Investing always means comparing the current share price to intrinsic value, not to historic share prices.
Buying the business, not the share
The Value Investing approach is to view a stock as the means by which the shareholder becomes a part owner of a company. Value Investors make their profits by investing in quality companies, not by trading in shares.
Look at the worth of the asset, and don?t get distracted by external factors such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore don?t have any effect on the value of the business in the long run.
Example of Value Investing
One of the greatest investors of all time, Warren Buffett, has proven that Value Investing does work. He took the stock of Berkshire Hathaway from $12 a share in 1967 to $70,900 in 2002, thus beating the S&P 500’s performance by about 13.02% on average annually!
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