According to value investors, market overreacts to good as well as bad news which results in movements in stock prices that are not consistent with the long-term fundamentals of the company.
Therefore, value investors want to pick stocks at those instants where the share price becomes lower than the intrinsic value of the stock. They are in constant search for undervalued stocks.
Benjamin Graham is regarded to be the father of Value Investing. He developed the concept of fundamental security analysis and introduced value investing strategies. He was the author of two of the best books written on investing, “The Intelligent Investor” and “Security Analysis”.
His student, the great Warren Buffet also focuses on value investing and according to him, “It’s far better to buy a wonderful company at a fair price than to buy a fair company at a wonderful price.”
Now, what is the problem?
Why does not everyone become a millionaire through such a great tried and tested strategy of Value Investing?
It seems quite simple from the definition but the tricky part in value investing is to estimate the intrinsic value of the stock as it is a subjective matter. Some value investors look into the price to earnings ratio (P/E ratio), some look at current earnings and assets and do not give much weight to the future growth potential of the stock.
On the other hand, some value investors formulate their whole strategies on the basis of the estimation of future growth and cash flows. Analysts use various techniques in order to calculate the intrinsic value of a stock and decide whether the stock is undervalued or overvalued.
Undervalued stocks are those stocks whose current stock price is less than their intrinsic value. Value investors like to invest in these stocks.
Overvalued stocks are those whose current stock price is greater than their intrinsic value. Value investors tend to stay away from such stocks.
Value Investing Models
We shall discuss two of the most commonly used models for calculating the intrinsic value of a stock:
Dividend Discount Model
Many models calculate the intrinsic value of the security factor in variables largely pertaining to cash: dividends and future cash flows and utilize time value of money as well.
One of the most popular models based on this concept is the dividend discount model. This model is based on the idea that the intrinsic value of a stock should be calculated by estimating the expected value of the cash flows it will generate in the future.
The driving principle behind the model is the net present value (NPV) of the cash flows, which draws from the concept of the time value of money (TVM).
The fundamental value of the stock is calculated as follows:
Where: Div = Dividends expected in one-period
r = Required rate of return
Discounted Cash Flow
Discounted Cash Flow or DCF is the most commonly used valuation method to calculate a stock’s fundamental value.
Where: CFn = Cash flows in period ‘n’
d = Discount rate, Weighted Average Cost of Capital (WACC)
When intrinsic values are calculated through various methods, it becomes imperative to keep a margin of safety in order to cover some risk involved. The margin of safety is basically a principle according to which an investor buys stocks only if their value is much lower than the intrinsic value calculated.
Investors choose their own margin of safety according to their risk appetite.
Value Investing – Things to Keep in Mind
Value investing is not everyone’s cup of tea. There are some things that must be considered at all times if a person wants to become a value investor. Let us discuss some of them:
1. Keep a Long Time Frame for Investment
Suppose an aspiring value investor picks an undervalued stock and invests in it. It will be of no use if he/she will have to take out the money before it starts showing results. Sometimes, stocks may take a few months to a few years time to reach their intrinsic values.
One must have the confidence and patience to wait, else, all the hard work in selecting the stocks will be useless. One must develop the practice of thinking in terms of years or even decades instead of a few weeks or months.
2. Have the Confidence to Not Go With the Popular Sentiments
It is quite obvious that if the general public is recommending a stock and investing in it in huge amounts, it is unlikely that it will remain an undervalued stock.
Therefore, by definition only, undervalued stocks or stocks preferred by value investors are those stocks which are being overlooked by maximum investors either due to some other hot stocks or that sector is out of the limelight.
In such circumstances, one must have the confidence to invest in stocks which are completely out of focus of the general public. A beautiful quote by Benjamin Graham would help an investor to keep the required confidence –
“The stock investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.”
3. Always Have a Margin of Safety
The basic rule of any kind of investing is to protect one’s wealth against losses, otherwise, the purpose is definitely defeated. In the case of value investing also, it becomes essential to always have a margin of safety to avoid losses or minimise them to a large extent.
4. Stay Updated
We know that not researching various aspects of a company before investing is a kind of financial suicide.
But what happens once a person is invested in a stock?
The research and awareness should not end at the time of investing. One must be able to answer some basic questions about his/her stocks at all times.
The most important question is about good reasons to hold that stock. One must keep his/her knowledge about the stocks up to date by at least reading all the latest reports on the company and news related to not only the company but also its sector, etc.
If anything happens that has a negative impact on the stock’s intrinsic value, one must reconsider his/her situation and take calls accordingly.
Value Investing – Conclusion
So, now we know the definition of value investing, the basic principle behind it and some of the commonly used models to calculate the intrinsic value of stocks in order to find undervalued stocks for our portfolios.
But one must remember that there are things that are equally important as the stock selection in order to earn profits.
Some of them are having the spare money for value investing so as not to take out money even before the stock has reached its intrinsic value, having the confidence to go against the popular opinion of the general public, having the patience to wait for years or even decades to reap the benefits of value investing.
In case you are looking to get started with Value Investing and need the assistance of any kind, let us help you in taking things forward: