Value Investing

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 numerous 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.

Understanding Value Investing

The basic concept behind everyday value investing is straightforward: If you know the true value of something, you can save truckload of cash 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 likewise, 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 variances — but that doesn't change what you're getting for your money.

Just like keen shoppers would argue that it's a horrible idea to pay full price for a TV since TVs go on sale several times every year, clever value investors believe stocks work the same way. Of course, unlike TVs, stocks won't go on sale at predictable times of the year like Black Friday, and their sale prices will not 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 as long as possible, investors can be rewarded handsomely.

Value investing developed from a concept by Columbia Business School professors Benjamin Graham and David Dodd in 1934 and was popularized in Graham's 1949 book, "The Intelligent Investor**."**

Intrinsic Endlessly value Investing

In the stock market, the equivalent of a stock being cheap or discounted is when its shares are undervalued. Value investors hope to profit from shares they perceive to be deeply discounted.

Investors use different metrics to attempt to find the valuation or intrinsic value of a stock. Intrinsic value is a combination of utilizing financial analysis, for example, studying a company's financial performance, revenue, earnings, cash flow, and profit as well as fundamental factors, including the company's brand, business model, target market, and competitive advantage. Some metrics used to value a company's stock include:

Price-to-book (P/B) or book value, which measures the value of a company's assets and compares them to the stock price. In the event that the price is lower than the value of the assets, the stock is undervalued, expecting the company isn't in financial hardship.
Price-to-earnings (P/E), which shows the company's track record for earnings to determine on the off chance that the stock price isn't reflecting the earnings or is all undervalued.
Free cash flow, which is the cash generated from a company's revenue or operations after the costs of expenditures have been subtracted. Free cash flow is the cash remaining after expenses have been paid, including operating expenses and large purchases called capital expenditures, which is the purchase of assets like equipment or upgrading a manufacturing plant. In the event that a company is generating free cash flow, it'll have money left over to invest in store for the business, pay off debt, pay dividends or rewards to shareholders, and issue share buybacks.

Of course, there are numerous other metrics used in the analysis, including examining debt, equity, sales, and revenue growth. After reviewing these metrics, the value investor can decide to purchase shares if the comparative value — the stock's current price opposite its company's intrinsic worth — is attractive enough.

Margin of Safety

Value investors require some room for error in their estimation of value, and they often set their own "margin of safety," based on their particular risk tolerance. The margin of safety principle, one of the keys to successful value investing, is based on the premise that buying stocks at bargain prices gives you a better chance at earning a profit later when you sell them. The margin of safety likewise makes you less likely to lose money in the event that the stock doesn't perform as you had expected.

Value investors use the same kind of reasoning. On the off chance that a stock is worth $100 and you buy it for $66, you'll make a profit of $34 simply by waiting at the stock's cost to rise to the $100 true value. On top of that, the company could develop and become more valuable, allowing you an opportunity to make even more money. On the off chance that the stock's price rises to $110, you'll make $44 since you bought the stock on sale. In the event that you had purchased it at its full price of $100, you would just make a $10 profit.

Benjamin Graham, the father of value investing, possibly bought stocks when they were priced at two-thirds or less of their intrinsic value. This was the margin of safety he felt was necessary to earn the best returns while limiting investment downside.

Markets Are Not Efficient

Value investors don't believe in the efficient-market hypothesis, which says that stock prices already take all information about a company into account, so their price generally reflects their value. Instead, value investors believe that stocks might be over-or underpriced for a variety of reasons.

For example, a stock may be underpriced because the economy is performing poorly and investors are panicking and selling (similar to the case during the Great Recession). Or on the other hand a stock may be overpriced because investors have gotten too excited about an unproven new technology (similar to the case of the dot-com bubble). Psychological biases can push a stock price up or down based on news, for example, disappointing or unexpected earnings announcements, product recalls, or litigation. Stocks may likewise be undervalued because they trade under the radar, meaning they're inadequately covered by analysts and the media.

Don't Follow the Herd

Value investors possess numerous characteristics of contrarians — they don't follow the herd. In addition to the fact that they reject the efficient-market hypothesis, but when everyone else is buying, they're often selling or standing back. When everyone else is selling, they're buying or holding. Value investors don't buy trendy stocks (because they're typically overpriced). Instead, they invest in companies that aren't household names if the financials check out. They likewise take a second look at stocks that are household names when those stocks' prices have plummeted, believing such companies can recover from setbacks in the event that their fundamentals remain strong and their products and services actually have quality.

Value investors just care about a stock's intrinsic value. They think about buying a stock for what it really is: a percentage of ownership in a company. They need to claim companies that they know have sound principles and sound financials, regardless of what everyone else is talking about or doing.

Value Investing Requires Diligence and Patience

Estimating the true intrinsic value of a stock involves some financial analysis but likewise involves a fair amount of subjectivity — meaning on occasion, it very well may be more of an art than a science. Two different investors can analyze the exact same valuation data on a company and arrive at different decisions.

Some investors, who look just at existing financials, don't put a lot of faith in estimating future growth. Other value investors center primarily around a company's future growth potential and estimated cash flows. And some do both: Noted value investment masters Warren Buffett and Peter Lynch, who ran Fidelity Investment's Magellan Fund for a long time are both known for dissecting financial statements and looking at valuation multiples, to identify cases where the market has mispriced stocks.
Despite different approaches, the underlying logic of value investing is to purchase assets for less than they are currently worth, hold them as long as possible, and profit when they return to the intrinsic value or above. It doesn't provide instant satisfaction. You can't expect to buy a stock for $50 on Tuesday and sell it for $100 on Thursday. Instead, you might have to stand by years before your stock investments pay off, and you will infrequently lose money. That's what the good news is, for most investors, long-term capital gains are taxed at a lower rate than short-term investment gains.

Like all investment strategies, you must have the patience and diligence to stick with your investment philosophy. Some stocks you should buy because the fundamentals are sound, but you'll have to stand by assuming it's overpriced. You'll need to buy the stock that is generally attractively priced at that moment, and assuming no stocks meet your criteria, you'll have to sit and stand by and let your cash sit idle until an opportunity arises.

Why Stocks Become Undervalued

In the event that you don't believe in the efficient market hypothesis, you can identify reasons why stocks may be trading below their intrinsic value. Here are a few factors that can drag a stock's price down and make it undervalued.

Market Moves and Herd Mentality

Sometimes people invest irrationally based on psychological biases rather than market fundamentals. When a specific stock's price is rising or when the overall market is rising, they buy. That's what they see assuming that they had invested 12 weeks prior, they could have earned 15% by now, and they develop a fear of missing out.

Conversely, when a stock's price is falling or when the overall market is declining, loss aversion compels people to sell their stocks. So instead of keeping their losses on paper and waiting for the market to change directions, they accept a certain loss by selling. Such investor behavior is boundless to the point that it affects the prices of individual stocks, exacerbating both upward and downward market movements creating excessive moves.

Market Crashes

When the market reaches an unbelievable high, it normally results in a bubble. But because the levels are unsustainable, investors end up panicking, leading to a massive selloff. This results in a market crash. That happened in the early 2000s with the dotcom bubble, when the values of tech stocks shot up beyond what the companies were worth. We saw the same thing happened when the housing bubble burst and the market crashed in the mid-2000s.

Unnoticed and Unglamorous Stocks

Look beyond the thing you're hearing in the news. You might find really great investment opportunities in undervalued stocks that may not be on people's radars like small caps or even foreign stocks. Most investors need to take part in the next big thing, for example, a technology startup instead of a boring, established consumer durables manufacturer.

For example, stocks like Meta (formerly Facebook), Apple, and Google are more likely to be affected by herd-mentality investing than conglomerates like Proctor and Gamble or Johnson and Johnson.

Bad News

Even good companies face setbacks, like litigation and recalls. However, just because a company experiences one negative event doesn't mean that the company isn't still fundamentally valuable or that its stock won't bounce back. In other cases, there might be a segment or division that puts a dent in a company's profitability. But that can change assuming the company decides to dispose of or close that arm of the business.

Analysts do not have a great track record for predicting the future, and yet investors often panic and sell when a company announces earnings that are lower than analysts' expectations. But value investors who can see beyond the downgrades and negative news can buy stock at deeper discounts because they are able to recognize a company's long-term value.

Cyclicality

Cyclicality is defined as the changes that affect a business. Companies are not immune to ups and downs in the economic cycle, whether that is seasonality and the time of year, or consumer attitudes and moods. All of this can affect profit levels and the price of a company's stock, but it doesn't affect the company's value in the long term.

Value Investing Strategies

The key to buying an undervalued stock is to completely research the company and make common-sense decisions. Value investor Christopher H. Browne recommends asking in the event that a company is likely to increase its revenue by means of the following methods:

Raising prices on products
Increasing sales figures
Decreasing expenses
Selling off or closing down unprofitable divisions

Browne likewise suggests studying a company's competitors to evaluate its future growth prospects. But the answers to these questions tend to be speculative, with next to no real supportive numerical data. Simply put: There are no quantitative software programs yet available to help achieve these answers, which makes value stock investing somewhat of a grand guessing game. Thus, Warren Buffett recommends investing just in industries you have personally worked in, or whose consumer goods you are know about, like cars, clothes, appliances, and food.

One thing investors can do is choose the stocks of companies that sell high-demand products and services. While it's difficult to predict when innovative new products will capture market share, it's easy to gauge how long a company has been in business and study how it has adapted to challenges over time.

Insider Buying and Selling

For our purposes, insiders are the company's senior managers and directors, plus any shareholders who own somewhere around 10% of the company's stock. A company's managers and directors have unique knowledge about the companies they run, so in the event that they are purchasing its stock, it's reasonable to assume that the company's prospects look favorable.

Likewise, investors who own no less than 10% of a company's stock wouldn't have bought so a lot on the off chance that they didn't see profit potential. Conversely, a sale of stock by an insider doesn't necessarily point to bad news about the company's anticipated performance — the insider could simply need cash for quite a few personal reasons. Nonetheless, if mass sell-offs are happening by insiders, such a situation might warrant further in-depth analysis of the reason behind the sale.

Analyze Earnings Reports

At some point, value investors have to look at a company's financials to see how its performing and compare it to industry peers.

Financial reports present a company's annual and quarterly performance results. The annual report is SEC form 10-K, and the quarterly report is SEC form 10-Q. Companies are required to file these reports with the Securities and Exchange Commission (SEC). You can find them on the SEC website or the company's investor relations page on their website.

You can learn a great deal from a company's annual report. It will explain the products and services offered as well as where the company is heading.

Analyze Financial Statements

A company's balance sheet provides a big picture of the company's financial condition. The balance sheet comprises of two sections, one listing the company's assets and another listing its liabilities and equity. The assets section is broken down into a company's endlessly cash equivalents; investments; accounts receivable or money owed from customers, inventories, and fixed assets like plant and equipment.

The liabilities section records the company's accounts payable or money owed, accrued liabilities, short-term debt, and long-term debt. The shareholders' equity section reflects how much money is invested in the company, the number of shares that are outstanding, and the amount of the company possesses in retained earnings. Retained earnings is a type of savings account that holds the cumulative profits from the company. Retained earnings are used to pay dividends, for example, and are considered an indication of a healthy, profitable company.

The income statement tells you how much revenue is being generated, the company's expenses, and profits. Looking at the annual income statement rather than a quarterly statement will give you a better idea of the company's overall position since many companies experience variances in sales volume during the year.

Studies have consistently found that value stocks outperform growth stocks and the market as a whole, over the long term.

Habitual slouch Value Investing

It is possible to become a value investor while never reading a 10-K. Habitually lazy person investing is a passive strategy of buying and holding a few investing vehicles for which someone else has already done the investment analysis — i.e., mutual funds or exchange-traded funds. On account of value investing, those funds would be those that follow the value strategy and buy value stocks — or track the moves of high-profile value investors, like Warren Buffett.

Investors can buy shares of his holding company, Berkshire Hathaway, which claims or has an interest in dozens of companies the Oracle of Omaha has researched and evaluated.

Risks with Value Investing

Likewise with any investment strategy, there's the risk of loss with value investing despite it being a low-to-medium-risk strategy. Below we highlight a few of those risks and why losses can happen.

The Figures are Important

Numerous investors use financial statements when they make value investing decisions. So assuming you rely on your own analysis, make sure you have the most updated information and that your calculations are accurate. If not, you might end up making a poor investment or pass up a great one. In the event that you're not yet confident in that frame of mind to read and analyze financial statements and reports, keep studying these subjects and don't place any trades until you're genuinely ready.

One strategy is to read the footnotes. These are the notes in Form 10-K or Form 10-Q that explain a company's financial statements in greater detail. The notes follow the statements and explain the company's accounting methods and elaborate on reported results. On the off chance that the footnotes are unintelligible or the information they present seems unreasonable, you'll have a better idea of whether to pass on the stock.

Extraordinary Gains or Losses

There are some incidents that might appear on a company's income statement that should be considered exceptions or extraordinary. These are generally beyond the company's control and are called extraordinary item — gain or extraordinary item — loss. Some examples include lawsuits, restructuring, or even a natural disaster. On the off chance that you exclude these from your analysis, you can probably get a sense of the company's future performance.

However, think critically about these items, and use your judgment. On the off chance that a company has a pattern of reporting the same extraordinary item a large number of years, it probably won't be too extraordinary. Likewise, assuming there are unexpected losses many years, this can be an indication that the company is having financial problems. Extraordinary items are supposed to be unusual and nonrecurring. Likewise, beware of a pattern of write-offs.

Overlooking Ratio Analysis Flaws

Earlier sections of this tutorial have discussed the calculation of different financial ratios that help investors diagnose a company's financial health. There isn't just one method for determining financial ratios, which can be fairly problematic. The following can affect how the ratios can be interpreted:

Ratios can be determined utilizing 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 assuming that the ratios are the same — might be difficult since companies have different accounting practices.

Buying Overvalued Stock

Overpaying for a stock is one of the primary risks for value investors. You can risk losing part or the entirety of your money in the event that you overpay. The same goes in the event that you buy a stock close to its fair market value. Buying a stock that is undervalued means your risk of losing money is reduced, even when the company doesn't do well.

Recall that one of the fundamental principles of value investing is to build a margin of safety into every one of your investments. This means purchasing stocks at a price of around two-thirds or less of their intrinsic value. Value investors need to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.

Not Diversifying

Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. Instead, we are educated to invest in multiple stocks or stock indexes with the goal that we have exposure to a wide variety of companies and economic sectors. However, some value investors believe that you can have a diversified portfolio even on the off chance that you just own a small number of stocks, as long as you choose stocks that represent different industries and different sectors of the economy. Value investor and investment manager Christopher H. Browne recommends possessing at least 10 stocks in his "Little Book of Value Investing." According to Benjamin Graham, a popular value investor, you should look at picking 10 to 30 stocks if you have any desire to diversify your holdings.

Another set of experts, however, say differently. If you have any desire to get big returns, try picking just a few stocks, according to the creators of the second edition of "Value Investing for Dummies." They say having more stocks in your portfolio will probably lead to an average return. Of course, this advice assumes that you are great at picking winners, which may not be the situation, particularly assuming you are a value-investing novice.

Listening to Your Emotions

It is difficult to ignore your emotions when making investment decisions. Even on the off chance that you can take a detached, critical standpoint when evaluating numbers, fear and excitement might creep in when it comes time to really use part of your hard-earned savings to purchase a stock. More importantly, once you have purchased the stock, you might be tempted to sell it assuming that the price falls. Keep in mind that the point of value investing is to resist the temptation to panic and go with the herd. So don't fall into the trap of buying when share prices rise and selling when they drop. Such behavior will obliterate your returns. (Playing follow-the-leader in investing can quickly become a dangerous game.

Example of a Value Investment

Value investors seek to profit from market overreactions that normally come from the release of a quarterly earnings report. As a historical real example, on May 4, 2016, Fitbit released its Q1 2016 earnings report and saw a sharp decline in after-hours trading. After the whirlwind was over, the company lost nearly 19% of its value. However, while large decreases in a company's share price are normal after the release of an earnings report, Fitbit met analyst expectations for the quarter as well as even increased guidance for 2016.

The company earned $505.4 million in revenue for the principal quarter of 2016, up more than half when compared to the same time period from one year prior. Further, Fitbit expects to generate between $565 million and $585 million in the second quarter of 2016, which is above the $531 million forecasted by analysts.

The company looks to be strong and developing. However, since Fitbit invested heavily in research and development costs in the main quarter of the year, earnings per share (EPS) declined when compared to a year prior. This is all average investors needed to jump on Fitbit, selling off enough shares to cause the price to decline. However, a value investor looks at the fundamentals of Fitbit and understands it is an undervalued security, poised to potentially increase from now on.

The Bottom Line

Value investing is a long-term strategy. Warren Buffett, for example, buys stocks fully intent on holding them indefinitely. He once said, "I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for a considerable length of time." You will probably need to sell your stocks when it comes time to make a major purchase or retire, but by holding a variety of stocks and keeping a long-term outlook, you can sell your stocks just when their price exceeds their fair market value (and the price you paid for them).

Highlights

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.
Value investors use financial analysis, don't follow the herd, and are long-term investors of quality companies.

FAQ

What Are Common Value Investing Metrics?

Along with breaking down a company's price-to-earnings ratio, which can illustrate how expensive a company is in relation to its earnings, common metrics include the price-to-book ratio, which compares a company's share price to its book value (P/BV) per share.Importantly, this highlights the difference between a company's book value and its market value. A B/V of 1 would indicate that a company's market value is trading at its book value. Free cash flow (FCF) is another, which shows the cash that a company has on hand after expenses and capital expenditures are accounted for. At last, the debt-to-equity ratio (D/E) looks at the extent to which a company's assets are financed by debt.

What Is a Value Investment?

Value investing is an investment philosophy that involves purchasing assets at a discount to their intrinsic value. This is otherwise called a security's margin of safety. Benjamin Graham, known as the father of value investing, first established this term with his landmark book, The Intelligent Investor, in 1949. Notable proponents of value investors include Warren Buffett, Seth Klarman, Mohnish Pabrai, and Joel Greenblatt.

Who Is Mr. Market?

First coined by Benjamin Graham, "Mr. Market" represents a hypothetical investor that is prone to sharp mood swings of fear, apathy, and euphoria. "Mr. Market" represents the consequences of emotionally reacting to the stock market, rather than rationally or with fundamental analysis. As an archetype for her behavior, "Mr. Market" speaks to the price changes inherent in markets, and the emotions that can influence these on extreme scales, like greed and fear.

What Is an Example of Value Investing?

Common sense and fundamental analysis underlie large numbers of the principles of value investing. The margin of safety, which is the discount that a stock trades at compared to its intrinsic value, is one leading principle. Fundamental metrics, like the price-to-earnings (PE) ratio, for example, illustrate company earnings in relation to their price. A value investor might invest in a company with a low PE ratio because it provides one barometer for determining on the off chance that a company is undervalued or overvalued.