The Basics of Value Investing

Value investing is a school of thought regarding the selection of investments. Ben Graham and David Dodd, from the Columbia School of Business, started teaching the idea of value investing in 1928. Experts define value investing in many ways and have many conflicting opinions about it. But, most theories include finding underpriced investments via fundamental analysis.

Warren Buffett was a pupil of Graham’s. While Graham was likely to purchase nearly any stock that met certain fundamental analysis metrics, Buffett didn’t stop there. He was more concerned about the future prospects of a business. Graham didn’t recommend using future projections, since they were unknown values.

Mr. Buffet uses a fundamental analysis to ensure a company is financially solid and likely to weather difficult financial times. He also looks for undervalued companies.

Academics have studied the viability of value stock picking strategies and have found them to be superior to both the growth strategies and the market overall. However, this advantage is only found in the long-term.

Check out these key points regarding value investing:

  1. Value investing largely consists of focusing on companies that are selling at a discount compared to the intrinsic value. The intrinsic value can be thought of as the true value of a company’s stock. It isn’t just the assets. It also includes intangible factors.
    • A value investor is seeking a stock that’s being undervalued by the market. The actual intrinsic value can’t be truly determined with absolute certainty.
    • If a company has a certain amount of physical inventory in the form of construction materials, a valuation is accurate. However, intrinsic value is more challenging to determine in more technological companies. Companies with intellectual assets are especially difficult to value accurately.
  1. The intrinsic value of a business is much greater than the sum of its assets. For example, Coca-Cola is much more valuable than its buildings and beverage concentrate inventory. The brand, customer loyalty, and expected future earnings make it much more valuable.
    • However, when a business completely fails, the intrinsic value may be very close to the market value of the underlying assets.
    • Though quite rare, it’s possible to find companies whose assets alone exceed their stock valuation.
  1. Many websites and brokerage firms assign values to stocks that are meant to represent the intrinsic value. This might be a good starting point to start your own research. However, keep in mind that these are simply best guesses on the part of the analyst.
    • Predicting future earnings, dividends, and other metrics 10 years into the future isn’t an exact science.
  2. The spread between the intrinsic value and the current price is commonly referred to as the “margin of safety.” So a stock selling at $60 per share, but valued by you to be worth $80 per share, has a 25% margin of safety since $60 is 25% less than $80.
  3. Value investing requires a significant time horizon. If the market has undervalued a company, it can take many years for the reality to catch up to the illusion.

Value investing is a great methodology for those willing to put in the necessary time and effort to accurately value companies. Investing requires great patience and the avoidance of emotional decision-making. Logic and rational thinking are critical components to one’s success.

If you’ve been investing without doing extensive research, it might be worth considering a more analytical approach. The numbers aren’t the entire story, but they’re certainly a significant factor.