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Value investing is a strategy where investors aim to buy stocks, bonds, real estate, or other assets for less than they are worth. Investors who pursue value investing learn to uncover the intrinsic value of assets, and develop the patience to wait until they can be purchased at prices that are lower than this intrinsic value.

Benjamin Graham is generally regarded as the father of value investing. Graham’s Security Analysis, published in 1934, and The Intelligent Investor, published in 1949, established the precepts of value investing, including the concept of intrinsic value and establishing a margin of safety.

Besides those two invaluable tomes Graham authored, his most lasting contribution to value investing was his role in setting the stage for legendary investor Warren Buffett. Buffett studied under Graham at Columbia University and worked for a short time at Graham’s firm.

As the CEO of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), Buffett is perhaps the best-known value investor. Buffett cut his teeth in value investing in his early 20s and used the strategy to deliver immense returns for investors in the 1960s before taking control of Berkshire in the 1970s.

However, the influence of Charlie Munger, Berkshire’s vice chairman and Buffett’s investing partner for many decades, along with Buffett’s evolution as an investor, has changed Buffett’s strategy. Instead of purely buying undervalued assets, Buffett shifted to identifying high-quality businesses at reasonable values.

What is value investing?

Value investing is an investment strategy that focuses on stocks that are underappreciated by investors and the market at large. The stocks that value investors seek typically look cheap compared to the underlying revenue and earnings from their businesses. Investors who use the value investing strategy hope the stock price will rise as more people come to appreciate the true intrinsic value of the company’s fundamental business.

The greater the difference between the intrinsic value and the current stock price, the greater the margin of safety for value investors looking for investment opportunities. Because not every value stock will turn its business around successfully, that margin of safety is important for value investors to minimize their losses when they’re wrong about a company.

Two Approaches to Valuation

Ultimately, there are dozens of valuation models but only two valuation approaches: intrinsic and relative. In intrinsic valuation, we begin with a simple proposition: The intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows. Assets with high and stable cash flows should be worth more than assets with low and volatile cash flows. You should pay more for a property that has long-term renters paying a high rent than for a more speculative property with not only lower rental income, but more variable vacancy rates from period to period.

While the focus in principle should be on intrinsic valuation, most assets are valued on a relative basis. In relative valuation, assets are valued by looking at how the market prices similar assets. Thus, when determining what to pay for a house, you would look at what similar houses in the neighborhood sold for. With a stock, that means comparing its pricing to similar stocks, usually in its “peer group.” Thus, Exxon Mobil will be viewed as a stock to buy if it is trading at 8 times earnings while other oil companies trade at 12 times earnings. While there are purists in each camp who argue that the other approach is useless, there is a middle ground. Intrinsic valuation provides a fuller picture of what drives the value of a business or stock, but there are times when relative valuation will yield a more realistic estimate of value. In general, there is no reason to choose one over the other, since nothing stops you from using both approaches on the same investment. In truth, you can improve your odds by investing in stocks that are undervalued not only on an intrinsic basis but also on a relative one.

How to Calculate Intrinsic Value

Fundamentally, calculating a company’s intrinsic value involves determining the present value of a company’s future cash flows. This in turn requires estimating future cash flows, and the interest rate to use to determine the present value of those cash flows. Given these assumptions, it’s easy to understand why intrinsic value is often a range rather than a precise number.

Buffett called intrinsic value the “only logical approach” to evaluating the relative attractiveness of investments and businesses.

“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life,” he wrote.

There are a number of metrics that some use to determine whether a company is selling below its intrinsic value. While none of these should be relied upon blindly, they can be a helpful starting point.

Determine Intrinsic Value with the Price-to-Book Ratio

Price to Book, or the P/B ratio, compares the stock price of a company to its book value per share. Book value per share is the company’s net worth (assets minus liabilities) divided by the number of outstanding shares. In some cases, investors will exclude certain intangible assets (e.g., goodwill) from the calculation of the PB ratio.

In theory, any value below 1.0 indicates that a company’s stock is selling for less than the net worth of the company. Today, some banks trade below their book value, while some growth companies trade at many multiples of their net worth.

There is, however, no one P/B ratio that defines value versus growth investments, as these numbers change throughout business cycles. As stock prices go up, the P/B Ratio goes up, and as prices go down, so does the ratio.

Determine Intrinsic Value with the Price-to-Earnings Ratio

Price to earnings, or the P/E ratio, compares a company’s stock price to its annual earnings. A P/E ratio of 15, for example, indicates that it will take 15 years at the company’s current earnings to equal the cost of the share.

The lower the P/E ratio, the more likely the company is considered a value stock. While there is no fixed level that automatically qualifies a stock as a value investment, the PE ratio should be lower than the average P/E ratio of the market as a whole.

As with the P/B ratio, keep in mind that a lower P/E ratio doesn’t mean a company is a good investment. These metrics are a starting point for further analysis.

Alternatives to Value Investing

Value investing is not the only approach to stock selection. Perhaps the most important alternative is growth investing. Where value investing looks for companies with stocks that are on sale, growth investing looks for companies that are growing much faster than most other companies.

Where a value investor may look for a low P/E ratio or P/B ratio, a growth investor is more concerned with how quickly a company is growing its revenue and profits. In fact, many growth companies have astronomically high P/E and P/B ratios.

Over time, both approaches can outperform average market returns. In the current market, growth investing has outperformed value investing for a number of years. This can be seen most clearly in the returns of companies such as Bajaj Finance, Britannia Industries and Deepak Nitrite.  In the past, however, there have been long periods where value investing has performed better.

Beyond value investing and growth investing, some alternatives eschew fundamental analysis completely. For example, those following a technical analysis approach that use past market data in an effort to predict future market prices. Likewise, day traders rely on short-term fluctuations in the market rather than an assessment of intrinsic value.


Advantages of Value Investing

  1. Great Stocks, Lower Rates One of the biggest advantages of value investing is buying stocks that are going to grow tremendously in the future for a very low price. Since other investors are not yet aware of the Underlying potential of the stock, value investors can buy these stocks at a very low rate and reap huge profits in the future.
  1. Tried and Tested Strategy Value investing is being done for almost a century now. It has proved to be a successful investment strategy provided you know the art of picking up the right stocks. A seasoned investor can make huge profits once he knows where to put his money wisely.
  1. Based on Facts The value stocks are determined based on the fundamental analysis. The stocks are chosen after a deep study of the company and its future prospects. Investing on solid facts and research tends to be better strategy rather than investments based on speculation.

Disadvantages of Value Investing

  1. Huge Risk Factor Investing in undervalued stocks in hopes of a future turnaround carries a huge risk. There may be miscalculation resulting in heavy losses for the investor.
  1. Less Diversification The selected value stocks may belong to a particular sector which may be expected to soar. Investing in only a few concentrated sectors increases the portfolio risk, due to lack of diversification.
  1. Long Wait  It may take years for the intrinsic value of a stock to maximise. This results in lengthy holding periods for the investor. It is not even sure if the stocks would rise to their full potential, even after all the waiting, thus, making it risky due to uncertain returns
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