Last Updated on Jan 18, 2022 by Manonmayi

Benjamin Graham considered the ‘Father of Value Investing’, popularised an investment paradigm in the 1920s known as -value investing. Business tycoons and investors, such as Warren Buffett and Seth Klarman, also religiously follow this technique for their investments. 

The concept is based on a stock‘s valuation as being either overvalued and undervalued. Value investing refers to a strategy followed by investors where they pick out undervalued stocks in the market. Investors do a lot of research and use their expertise to find these undervalued stocks. 

In other words, value investing could also mean studying and investing in high potential unpopular stocks that often go unnoticed. The investment is locked in for a long period, again a basic yet most important tenant of this strategy. Let us explore this in future detail.

This article covers:

How does value investing work?

The efficient market hypothesis states that the markets have perfect information and determine the equilibrium value of shares. But, stock markets are inherently volatile and prone to fluctuations. Share prices constantly change due to many uncontrollable factors. Many times, shares could be trading at a premium or, on the contrary, may remain beaten on the charts. In such a case, an investor needs to analyse and read if the stock’s current value is justified. 

Value investing, on many terms, is contrary to efficient market theory. Investors believe that the information is not fully available. If it is, it is not accurately analysed. This discrepancy causes some shares to trade on a value beneath their intrinsic value. 

Value investing, as a strategy, looks to profit from the market’s ignorance and invest in such stocks for the long term. Another interesting thing to note is that such investors may move against the herd giving them a real opportunity to profit if the stock moves as predicted. 

Undervaluation could be due to one bad quarter, sudden bad news or even poor economic situations. The company share price may thus suffer, even if the factors largely remain out of the company’s control. It may leave a negative impact, urging most investors to exit such shares.

However, value investing will demand that investors stick to quality stocks no matter the situation or how to further worse the stock could move. Value investing requires a lot of experience, analysis, and, most importantly, faith. 

However, one could follow a few basics to reap similar benefits. Those could be measuring the company’s growth potential, analysing management, studying revenues and expenses, etc. One could also research the company’s financial history and business model to have a fair idea of valuation. It could also be studied through models and various ratios. Let us see how that can be done.

Determining the intrinsic value

Investors employ several methods to find out the intrinsic value of shares. Some of these include:

P/E ratio

The price-to-earning ratio determines the relationship between the share price of the company and the earning per share. It is calculated as:

P/E ratio = (Current share price / Earnings per share)

It depicts how much money the investor would have to put in to earn a return of Rs. 1 on the share. For instance, assume the market price of the share to be Rs. 50. The EPS for the share is Rs. 15. So the P/E ratio will come out to be 3.33. This implies that the investor has to invest Rs. 3.33 to earn a return of Rs. 1 from the company. 

The P/E ratio has a reciprocal relationship with EPS. A decrease in EPS increases the P/E ratio. This increases the amount of investment required to earn a unit of return. A higher ratio may signify that the share may be overvalued.

P/B ratio

The price-to-book value ratio compares the share price to its book value. It is determined as:

P/B ratio = (Market value of the share / Book value of the share)

If the market value of the shares is lower than their book value, it indicates undervaluation. If the market price is higher, the stock could be considered overvalued.

Cash flows

Cash flows are the inflows that are earned on the share. These occur over the life of the investment. They are discounted to get an estimate of their present value. The total present value of all cash inflows is compared with the initial outflow, which is the purchase price. This helps in analysing whether the market price is justified. 

Apart from using these methods, one must note that valuations are subjective — the entire theory of value investing stands on this very notion that each investor values stock differently.

Operating with a margin

Even after a detailed analysis, the fact remains that the valuation of shares is an estimation. There is always room for error, and the value investors leave a margin for it.

This ‘margin of safety’ helps value investors mitigate their risk. It is the difference in the trading price of the stock with the inherent value of the company’s stock when a stock is underpriced that value investors bet on. This gives value investors the chance to earn a higher profit when the traded price catches up to the inherent value. However, if the stock does not perform as expected, they suffer calculated losses.

Conclusion

Value investing, in simple terms, is the potential to scan high potential, undervalued, often ignored stocks and invest in them for the long term. However, value investing involves immaculate analysis and research. The stock value determined is an estimate and may be different for everyone. It requires a lot of faith not just in your calculations but also in the company’s potential. 

Always remember – value investing is done for the long term. This means your funds are employed for a longer duration, and the results may not be immediate. But if you stick around for long enough, you may earn stellar returns. By doing your research and not following the crowd, you can explore the wide earning potential this method provides.

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