Introduction to Value Investing
Value investing is an investment strategy that can be used when investing in assets such as stocks, bonds, and real estate. The strategy hinges on buying these assets when they are being sold at prices less than their actual worth. It is therefore important for value investors to be able to accurately assess the natural or intrinsic value of an asset. The other side of the coin for value investing is patience. Value investors must be patient enough to wait for the asset to drop to the intrinsic price or lower before buying.
Perhaps the most important adherent of value investing is Warren Buffet, one of the richest men in the world and an extremely successful value investor. Buffet was a student of Benjamin Graham, who, along with David Dodd, wrote an important book about value investing called “Security Analysis.”
When it comes to stocks, a value investor considers the buying of a stock as being equivalent to owning the underlying company represented by the stock. This is in contrast to investors who treat stock investments as simple market plays with no concern beyond the stock price and movement.
Because a value investor considers owning a stock to be the same as owning a part of the underlying company, the investor is interested in the financial health and business prospects of said company. The process by which value investors study companies is called fundamental analysis. Using fundamental analysis, value investors come up with a price range that they believe reflects the intrinsic value of a stock.
Intrinsic value has been described by Warren Buffet as “the discounted value of the cash that can be taken out of a business during its remaining life.” Calculating intrinsic value starts by determining the future cash flows of a company, together with the applicable interest rate. Once this has been determined, the present value of these future cash flows must then be calculated. With this starting point, certain metrics can be used to determine intrinsic value.
One of these metrics is the price-to-book ratio. Also known as the P/B ratio, this metric compares the stock price to the book value per share. The book value per share is the company’s net worth divided by the number of shares. The net worth of a company is calculated by deducting liabilities from assets. A company with a P/B ratio less than 1 can be considered as selling at a discount because it is selling for less than its net worth.
Another popular value investing metric is the price-to-earnings ratio, or P/E ratio. This compares the stock price to annual earnings. A P/E ratio of 5 means that, based on current earnings, it will take 5 years for a company to equal its current share price. The lower the P/E ratio of a company, the more attractive it is to value investors. But what exactly qualifies as a low P/E ratio? One way to define this would be to compare a company’s P/E ratio with the P/E ratio of other companies in the same industry.
Alternatives to value investing include growth investing and technical analysis. Growth investors are focused on the revenue and profit growth of a company rather than the P/B or P/E ratios. In fact, most growth companies have characteristically high P/E and P/B ratios. Technical analysis is a way of investing that does not take into account the underlying company at all. Instead, it is concerned with forecasting the fluctuations of stock prices and making a profit from these movements.