What is Value Investing?

Key highlights:

• Value investing implies the stock market is not efficient and a company's current stock price is not always its fair value.
• Value investors aim to minimise losses by providing a margin of safety by investing below companies' intrinsic values.
• Value investment strategies calculate intrinsic value largely through the discounted cash flow (DCF) method.

In this article we provide you with a primer to help decide if being a value investor fits your goals.

What is value investing?

Value investing is one of those terms that has a definition, but means different things to different people. Let’s start with that definition.

Value investing is purchasing equity in a business believing its intrinsic worth is more than the cost to acquire. There are four areas here to break down:

1. What is intrinsic value worth? Intrinsic worth (or value) is the value of a company based on its current cash flows.
2. How do you determine intrinsic worth? The most recognised method for determining intrinsic value is discounted cash flow (DCF) analysis.
3. Are there different schools of thought surrounding intrinsic worth? Intrinsic value and the use of the DCF method was first established for value investing in the 1920s by Benjamin Graham and David Dodd. This remains the standard today.
4. 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.

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 Wall St stocks this is known as a 10-K SEC filing. It’s simply an annual report when analysing ASX stocks.

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? 7 Steps to follow

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

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.

P/E example: 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.

P/FCF example: 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.

PEG example: 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.

ROE example: 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.

P/B example: Stake Inc’s market capitalisation is $1b and its NAV is $2b. Therefore, its P/B is 0.5x.

Current ratio: 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.

Current ratio example: 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: 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.

Quick ratio example: 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.

Debt to equity example: 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 to 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 investment 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.

Value investing FAQs

Is value investing a good idea?

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.

Why invest in value stocks?

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.

Who are the two most famous value investors?

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.