How does value investing work?
Value investing is defined differently by various sources. Value investing, according to some, is an investment strategy that favors the acquisition of stocks with high dividend yields and low price-to-book ratios. Others assert that buying stocks with low P/E ratios is the only aspect of value investing. You may even hear that value investing is more about the income statement than the balance sheet.
Warren Buffet wrote the following in a 1992 letter to Berkshire Hathaway shareholders:
The term “value investing” itself seems redundant to us. If not the pursuit of value that is at least sufficient to justify the payment, what is “investing”? Investing in a stock with the intention of paying more than its calculated value in the hope that it can soon be sold for a higher price should be referred to as speculation—which, in our opinion, is neither illegal nor immoral.
The term “value investing” is frequently used, regardless of whether it is appropriate. Typically, it refers to the purchase of stocks with low price-to-book value, low price-earnings ratio, or high dividend yield characteristics. Sadly, even if these traits combine, they are far from conclusive in determining whether an investor actually buys something for what it is worth and, as a result, operates on the principle of gaining value from his investments. Similarly, opposite characteristics such as a high price-to-book value ratio, a high price-to-earnings ratio, and a low dividend yield do not disqualify a purchase as a “value” option.
The most accurate definition of value investing is that given by Buffett. Purchasing a stock at a price lower than its estimated value is known as value investing.
One of the benefits of value investing is that each share of stock represents an ownership stake in the company. A stock is more than just a piece of paper that can be sold for more money in the future. Stocks are more than just a right to receive cash distributions from the company in the future. Economically, each share ought to be valued as an undivided interest in all corporate assets, both tangible and intangible.
2) An intrinsic value exists for a stock. The economic value of the company that holds the stock is what determines the stock’s intrinsic value.
3) The stock market doesn’t work well. The Efficient Market Hypothesis is not supported by value investors. They believe that shares frequently change hands at prices that are either higher or lower than their intrinsic values. There are times when the difference between a share’s intrinsic value and its market price is large enough to allow for profitable investments. The founder of value investing, Benjamin Graham, used a metaphor to explain the inefficiency of the stock market. Value investors still make use of his Mr. Market analogy today:
Consider the scenario in which you own a $1,000 share in a private company. Mr. Market, one of your partners, is extremely accommodating. He offers to buy you out or sell you an additional interest on the basis of what he believes your interest is worth every day. His concept of value may at times appear plausible and supported by current business developments and prospects. On the other hand, Mr. Market frequently allows his enthusiasm or his fears to take over, and you find the value he suggests to be a little less than absurd.
4) Businesslike investing is the most intelligent form of investing. This is a line from “The Intelligent Investor” by Benjamin Graham. It is, in the opinion of Warren Buffett, the single most significant investment lesson he ever received. Investors should approach investing with the same level of seriousness and concentration as they do their chosen profession. An investor ought to treat the shares he purchases and sells in the same way that a merchant would treat the goods in his business. He shouldn’t make commitments if he doesn’t know enough about the “merchandise.” Furthermore, “a reliable calculation shows that it has a fair chance to yield a reasonable profit” is the only requirement for him to engage in any investment activity.
5) A safety margin is necessary for a genuine investment. A company’s working capital position, past earnings performance, land assets, economic goodwill, or (most commonly) a combination of any or all of the aforementioned can provide a safety margin. The difference between the business’s intrinsic value and the quoted price demonstrates the safety margin. It takes care of all the harm caused by the investor’s unavoidable wrong assumptions. As a result, the safety margin must be as wide as our human stupidity—that is, it should be a real chasm. If you know what you’re doing, buying dollar bills for ninety-five cents only works; Even for us mere mortals, buying dollar bills for forty-five cents is likely to be profitable.
What Value Investing Is Not Buying a Stock for Less Than Its Calculated Value is not value investing. Surprisingly, this alone sets value investing apart from the majority of other investment strategies.
True (long-term) growth investors like Phil Fisher solely focus on the company’s value. They only want to buy shares in businesses that are truly extraordinary, so they don’t care about the price. They believe that these businesses will be able to benefit from the wonders of compounding due to their phenomenal growth over many years. Even a price that seems high will eventually be justified if the company’s value increases rapidly and the stock is held for a sufficient amount of time.
Relative prices are taken into account by some so-called value investors. They base their decisions on how the market values other publicly traded companies in the same industry and each dollar of earnings in all businesses. In other words, even though the P/E ratio may not appear particularly low in absolute or historical terms, they may decide to purchase a stock simply because it appears to be cheap in comparison to its peers or because it is trading at a lower P/E ratio than the general market.
Should this strategy be referred to as value investing? I do not believe so. Despite the fact that it is a distinct investment philosophy, it is a perfectly valid one.
The calculation of an intrinsic value that is independent of the market price is necessary for value investing. Value investing does not include strategies that are based solely (or primarily) on empirical evidence. A logical structure is built on the tenets outlined by Graham and expanded upon by others, such as Warren Buffett.
Graham established a highly logical school of thought, even though value investing techniques may have empirical backing. Prior to verifiable hypotheses, correct reasoning is prioritized; and correlative relationships are emphasized more than causal ones. Quantitative value investing is an option; However, it is quantitative mathematically.
Calculus-based quantitative fields of study and pure arithmetic-based quantitative fields of study are clearly and consistently distinguished. Security analysis is treated by value investing as a strictly mathematical discipline. Despite the fact that Graham and Buffett were both well-known for having greater natural mathematical abilities than the majority of security analysts, they both stated that higher mathematics should not be used in security analysis. Only basic math knowledge is required to engage in true value investing.
Contrarian investing is sometimes referred to as a sect of value investing. In practice, those who identify as value investors and contrarian investors tend to purchase stocks that are very similar to one another.
Let’s take David Dreman, the author of “The Contrarian Investor,” as an example. David Dreman is known for being an unconventional investor. Because of his strong interest in behavioral finance, it is a good description for him. However, the distinction between value investors and contrarian investors is usually at best hazy. The following three metrics are used to derive Dreman’s contrarian investing strategies: value in relation to earnings, cash flow, and book value. Value investing, specifically so-called Graham and Dodd investing (a type of value investing named after the co-authors of “Security Analysis,” Benjamin Graham and David Dodd), is closely associated with these same metrics.
Conclusions In the end, the only way to define value investing is to pay less for a stock than its calculated value when the method used to calculate the stock’s value is truly unrelated to the stock market. The estimated intrinsic value is not affected by the stock market if the intrinsic value is determined by analyzing asset values or discounted future cash flows. However, value investing is not achieved by simply purchasing stocks at low price-to-earnings, price-to-book, and price-to-cash flow multiples in comparison to other stocks. Obviously, these tactics have worked well in the past and probably will continue to do so in the future.
One such efficient method is Joel Greenblatt’s “magic formula,” which frequently produces portfolios that resemble those of genuine value investors. But Joel Greenblatt’s magic formula doesn’t try to figure out how much the bought stocks are worth. Therefore, although the magic formula may work, it is not true value investing. Because he does calculate the intrinsic value of the stocks he purchases, Joel Greenblatt is himself a value investor. The readers of Greenblatt’s The Little Book That Beats The Market were investors who lacked the ability or desire to value businesses.
If you are not willing to calculate business values, you cannot be a value investor. Although you are not required to precisely value the company in order to be a value investor, you are required to value the company.
