Value investing is an investment strategy that involves selecting stocks that appear to be trading at a lower price than their actual or book value.
What is Value Investment?
Value investing is a strategy in which investors seek to buy stocks, bonds, real estate or other assets for less than their value. Investors pursuing value investing learn to uncover the intrinsic value of assets and develop the patience to wait until they are purchased at prices lower than this intrinsic value.
Value investing is no more or less than buying investment in sale.
Value investing has its origins in research by Benjamin Graham and David Dodd in the 1920s, when both men began teaching at Columbia Business School. Many of the value investing concepts are explained in their book “Security Analysis” and Graham’s book “The Smart Investor”. Warren Buffett, the most successful practitioner of value investing, was Graham’s student at Columbia.
Value investing starts from the premise that an investor buying a stake in a company owns a portion of the business. While this may seem obvious, many investors “play in the market” without considering the fundamentals of the companies they own.
As a business owner, the investor should evaluate companies’ financial statements to assess their intrinsic value. This type of assessment is known as fundamental analysis.
The intrinsic value is rarely a single number. Instead, intrinsic value is often a range, due to the many assumptions for evaluating a complex undertaking. This lack of certainty should not concern an investor.
In the words of Mr. Buffett, “It is better to be approximately right than exactly wrong.” Value investors will consider investing in a company whose price is at or below its true value.
How to Calculate Internal Value
Basically, calculating a company’s internal value involves determining the present value of a company’s future cash flows. This requires estimating future cash flows and the interest rate that will be used to determine the present value of those cash flows. Given these assumptions, it’s easy to understand why the true value is usually a range rather than an exact number.
Buffett called intrinsic value “the only sensible approach” to assessing the relative attractiveness of investments and businesses. “Intrinsic value can be defined simply: It is the discounted value of cash that can be received from a business over its remaining life,” wrote
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There are a number of metrics that some use to determine whether a company is selling below its fair value. While none of these are to be trusted blindly, they can be a useful starting point. Determine True Value with
P/B Ratio
The P/B ratio compares a company’s stock price to its book value per share. Book value per share is the company’s net worth (assets minus liabilities) divided by the number of shares outstanding. In some cases, investors will exclude certain intangible assets (for example, goodwill) from calculating the CU ratio.
In theory, anything below 1.0 indicates that a company’s stock has been sold for less than the company’s net worth. Today, some banks trade below book value, while some growth companies trade at multiples of their net worth.
However, as these numbers change throughout business cycles, there is no single P/B ratio that defines value versus growth investments. As stock prices rise, the P/B Ratio rises, and as prices fall, the ratio rises.
Determine Real Value with Price-to-Earnings Ratio
The price-to-earnings or P/E ratio compares a company’s stock price with its annual earnings. For example, an AP/E ratio of 15 indicates that it will take 15 years for the company to equal cost of stock in current earnings.
The lower the P/E ratio, the more likely the company is to be considered value stock. While there is no fixed level that automatically qualifies a stock as a value investment, the PE ratio must be lower than the average P/E ratio of the market as a whole. As with
P/B ratio, remember that a lower P/E ratio does not necessarily 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. It is perhaps the most important alternative growth investment. Where value investing looks for companies whose shares are up for sale, growth investing looks for companies that are growing much faster than many other companies.
Where a value investor is looking for a low P/E ratio or P/E ratio, the 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 several years. It is possible to see this most clearly in the returns of companies such as Amazon, Apple and Tesla. But there have been long periods in the past where value investing has performed better.
Beyond value investing and growth investing, some alternatives avoid fundamental analysis altogether. For example, those who follow the technical analysis approach that uses historical market data to predict future market prices. Similarly, day traders rely on short-term fluctuations in the market rather than an assessment of intrinsic value.
Value Investing with Mutual Funds
Mutual funds can offer investors an opportunity to have value investing exposure. Most large fund companies offer both actively managed and passively managed (i.e. index funds) value funds. As an example, the Vanguard Value Index Fund Admiral Shares (VVIAX) invests in value companies. A simple comparison of this fund with the Vanguard Growth Index Fund Admiral Shares (VIGAX) highlights the difference between these two investment approaches.
The average P/E ratio of the stocks that make up the value fund is 18.1. The growth fund average P/E ratio is 38.8. Likewise, while the P/B ratio of the value fund is 2.1, the P/B ratio of the growth fund is 8.2.
As noted earlier, growth funds have outperformed value funds over the past few years, and this is reflected in the 10-year performance of these two funds. The value fund yielded an average of 10.91%, while the growth fund yielded an average of 16.79%.
However, these data should not be interpreted as favoring growth investment over value investment. They will both spend their days in the sun. If someone is looking for a mix of these two investment styles, an S&P 500 index fund will offer this approach.
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