What is Value Investing?
If you are interested in learning more about value investing, understanding what it means is a good place to start. Like most people, I get most of my answers to life’s greatest questions from ‘The Google.’ So what did Google have to say? I’ve chosen three definitions from three difference sources followed by a discussion of the common elements in each and hopefully gain an understanding by the end of this article.
Wikipedia offered to following definition and it is a good place to start:
“Value investing generally involved buying securities whose shares appear under-priced…”
The Motley Fool adds an important distinction to the meaning or concept of ‘under-priced’:
“As the practice of buying shares … for less than their intrinsic value.”
What is intrinsic value? Intrinsic value can be defined several ways, but for our purposes, think of it as either the present value of all expected future net cash flows to the company, or as the value of the business’ ongoing operations, as opposed to book value, etc.
The Motley Fool provides a very useful explanation worth examining:
Value investing looks for mis-priced securities … those stocks that are selling at a discount to their intrinsic value.
Finally, Investopedia weighs in with the following definition of value investing:
“The strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued.”
Let’s use an analogy from the father of value investing, Benjamin Graham to help explain. Benjamin Graham used an analogy of the stock market as a voting machine over the short-run, but a weighing machine over the long-run. This analogy illustrates a point very well: A stock price, over the long-term, will more or less reflect the intrinsic value of a company.
So the one common thread is the idea of buying under-priced or undervalued companies. Therefore, we can summarize the practice of value investing as:
1. Discovering the intrinsic value or range of possible values of a company;
2. Comparing the current market price of a stock against the estimated intrinsic value and not against recent price movements; and
3. Purchasing the stock as a price that offers enough of a margin of safety since we can never really know the correct or absolute intrinsic value of any company.
But the big dilemma for value investing is estimating intrinsic value. Since this value is subject to estimates and professional and experiential judgment, two professional and seasoned investors can analyze the exact same stock and place a different value on the same company. How do value investors deal with this dilemma? They invest at a big enough discount to their estimates to allow some room for error in their analyses. This concept is commonly referred as a ‘margin of safety.’
How is intrinsic value estimated in practice? Typically, value investors select stocks with lower than average price-to-book or price-to-earnings ratios and/or high dividend yields. We will explore each one of these ratios in subsequent articles.
To Your Investing Success,
Kevin & Ali
The 360 Investing Guys