What is Value Investing?
Value investing is an investment paradigm that involves purchasing equities for less than what they’re worth.
What is value investing?
Value investing is a strategy where investors pick stocks trading below their intrinsic or book value. They identify market underestimations, as short-term stock price movements often don't align with a company's long-term fundamentals. Buying undervalued stocks at discounted prices offers profit opportunities.
There are four areas here to break down:
- What is intrinsic value worth? Intrinsic worth (or value) is the value of a company based on its current cash flows.
- How do you determine intrinsic worth? The most recognised method for determining intrinsic value is discounted cash flow (DCF) analysis.
- Are there different schools of thought surrounding intrinsic worth? Intrinsic value and the use of the DCF method were first established for value investing in the 1920s by Benjamin Graham and David Dodd. This remains the standard today.
- Does a value investing strategy only account for intrinsic value? Value investing has many different schools of thought. Some look only at intrinsic or book value, but not all. For example, Warren Buffett often accounts for intellectual property, market dominance, and other intangible aspects in his strategy. Benjamin Graham preferred to focus almost exclusively on ratios and purchase companies at 2/3 their net-net value. Net-net value investing is when a company is priced on its net current assets alone.
🎓 Learn more: How to tell if a stock is undervalued or overvalued?→
What do value investors look at?
Value investments require extensive investigation. The first thing any value investor should look at is a company’s most recent annual report. For U.S. listed companies this is known as a 10-K SEC filing, and for ASX listed companies it's an annual report.
Value investors tend to pay closer attention to the financial statements than management commentary, but that’s not to say you should discard the comments entirely. A lot of questions you might have are answered either in the footnotes or operations commentary of an annual report. Quarterly and half-yearly reports are also important, but tend to have less historical data and detail. Starting with the annual report often provides a roadmap for how to proceed.
While outside analysis can be useful, value investors are more concerned with intrinsic value. Therefore, they go straight to the source of truth to pull data for analysis.
🎓 Learn more: How to research stocks?→
What are the core value investing metrics?
There are eight key value investing ratios:
- P/E (Price to Earnings)
- P/FCF (Price to Free Cash Flow)
- PEG (Price Earnings Growth Rate)
- ROE (Return on Equity)
- P/B (Price to Book ratio)
- Current ratio
- Quick ratio
- Debt to equity
Value investing ratios
P/E (Price to Earnings)
P/E is one of the most commonly used ratios in finance. Simply put, it tells an investor how many years’ worth of earnings they are paying for the stock. Learn more about understanding what a good P/E ratio is.
If Stake Inc has a price of $1 per share and an Earnings Per Share (EPS) of $0.25, it has a P/E of 4x. It takes four years for Stake Inc to earn $1 per share outstanding based on the last 12 month’s results.
P/FCF (Price to Free Cash Flow)
Free Cash Flow is cash from operations minus capital expenditures. FCF shows how much money is moving through the company which helps determine the likelihood of past performance continuing. A negative number means the company is spending more cash than it is generating. This can occur even if the company booked a profit for the period due to a number of factors. If there’s a significant discrepancy, management would be expected to explain it in the footnotes.
Stake Inc has a market capitalisation of $1b and a FCF of $100m, it has a P/FCF of 10x. Stake Inc is generating more cash than it spends.
PEG (Price Earnings Growth Rate)
This ratio takes the P/E ratio and compares it to the average EPS growth rate. The time period in question is undefined and changes depending on the investor. Conventional wisdom sees a PEG value under 1 as undervalued, but remember PEG relies on past results which are no guarantee of future performance.
If Stake Inc has a P/E of 4x and an average EPS growth rate of 10% per year, its PEG would be 0.4x.
ROE (Return on Equity)
ROE takes net profit before common dividends, but after preferred (preferred dividends are paid to preferred stock shareholders before common shareholders) and dividing it by total shareholders’ equity. Value investors generally prefer companies with a track record of increasing return on equity.
With a net profit of $500m before common dividends and total shareholders’ equity of $2b, Stake Inc has a ROE of 25%.
P/B (Price to Book ratio)
P/B (sometimes referred to as the Price to Net Asset Value ratio) is the difference between a company’s tangible assets and liabilities on the balance sheet. Remember to only include tangible assets when calculating the Price to Book ratio; intangible assets like goodwill should be excluded. Conventional wisdom says a P/B ratio of less than 1 is undervalued.
Stake Inc’s market capitalisation is $1b and its NAV is $2b. Therefore, its P/B is 0.5x.
This quickly answers the question, ‘can this company pay its next 12 months’ worth of liabilities?’ The calculation is simple: take the current assets and divide it by current liabilities. In finance, ‘current’ means within the next 12 months. A ratio higher than 1 indicates the company can cover its next 12 months of liabilities.
With cash of $1b, accounts receivable of $250m and inventory of $50m, Stake Inc has current assets of $1.3b. Stake Inc also has debt due over the next 12 months of $300m and accounts payable of $100m. Therefore, with current liabilities of $400m, its current ratio is 3.3x.
Quick ratio is mostly the same as the current ratio, but it replaces current assets with ‘quick assets’. Quick assets only accounts for cash, cash equivalents, marketable securities and net accounts receivable. Basically the quick ratio does not include inventory.
With cash of $1b, accounts receivable of $250m and inventory of $50m, Stake Inc has quick assets of $1.25b. Stake Inc also has debt due over the next 12 months of $300m and accounts payable of $100m. Therefore, with current liabilities of $400m, its quick ratio is 3.1x.
Debt to equity
Debt to equity is used to determine how much of a company’s intrinsic value is owed to debt holders. The formula is total liabilities divided by NAV.
Stake Inc has total liabilities of $600m and a NAV of $2b, its debt to equity ratio is 0.3x. Theoretically, if Stake Inc were sold for parts today, debt holders would get 30% of its value.
Is Warren Buffett a value investor?
Yes, Warren Buffett is a value investor.
Warren Buffett was not only heavily influenced by Benjamin Graham, but personally mentored by him. In fact, the most recent edition of the ‘value investor’s bible’, The Intelligent Investor by Benjamin Graham, has a foreword by Warren Buffett.
However, Warren Buffett’s style of value investing has key differences from Benjamin Graham’s. Chief among them is Warren Buffett’s focus on stocks with higher growth prospects, while Benjamin Graham focused more on valuation metrics and middle-of-the-road stocks with average earnings growth.
What is an example of a value investment?
Since his earliest days, Buffett’s investing principles have always tended to focus towards a buy-and-hold strategy. And his purchase of American Express (NYSE: AXP) shares in 1963 is one of the most classic examples of value investing.
Buffet initiated his investment in American Express after the company announced it had made a loan to a salad oil company that was a scam. This loan was so massive, shares collapsed 40% as the market worried the company’s future cash flows would not be enough to survive.
After doing a deep dive into the financials and with his understanding of the brand, Buffett figured the loss was temporary and more than recoverable. Believing that American Express’ intrinsic value was far above the market price at the time, he bought shares hand over fist in the undervalued stock and eventually made a killing.
What are the risks of value investing?
The main risk when using a value investing strategy is falling into a value trap.
A value trap is a company considered ‘cheap’ compared to its peers based on its valuation ratios, but has been that way for a long time, usually for specific reasons. A classic example of this is the newspaper industry in the U.S. Here, a shifting and tightening environment has caused many of these listed companies to trade below what would otherwise be considered their ‘fair value’.
What is the difference between value investing and growth investing?
A growth investing strategy examines the potential for an enterprise to expand revenue or profits over the long run. While both are long-term strategies, growth investors are not concerned with intrinsic value as they are focusing on extraordinary business developments that justify the higher prices investors pay. Consequently, growth investors base their valuations as a multiple of a company’s projected revenue or profit growth.
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Value investing FAQs
Everyone likes a bargain, and value investing is designed for people looking to identify companies trading below their true underlying value. In theory, the stock market will over time realise the company’s intrinsic value and adjust accordingly, leading to capital gains for those who bought in earlier.
Many successful investors also enjoy the margin of protection provided by a value investment, since it’s priced lower than its intrinsic value.
Learn about some of the top value stocks on the ASX.
For those with a long-term horizon, value investing is an excellent strategy to consider. Value stocks are often not as volatile as those that might be favoured by other strategies. Theoretically, the risks are lower than relying on market value-based investing strategies.
The most well-known value investors have to be the Oracle of Omaha, Warren Buffett, and his mentor Benjamin Graham is a close second above all other investors.
Megan is a markets analyst at Stake, with 7 years of experience in the world of investing and a Master’s degree in Business and Economics from The University of Sydney Business School. Megan has extensive knowledge of the UK markets, working as an analyst at ARCH Emerging Markets - a UK investment advisory platform focused on private equity. Previously she also worked as an analyst at Australian robo advisor Stockspot, where she researched ASX listed equities and helped construct the company's portfolios.