Cash Flow Statement From Balance Sheet And Income Statement Example What is Value Investing?

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What is Value Investing?

What is value investing?

Different sources define value investing differently. Some say value investing is an investment philosophy that favors buying stocks that are currently trading at low price-to-book ratios and have high dividend yields. Others say that value investing is all about buying stocks with low P/E ratios. Sometimes you’ll even hear that value investing has more to do with the balance sheet than the income statement.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffet wrote:

We believe that the term “value investing” itself is redundant. What is “investing” if not the act of seeking value that is at least sufficient to justify the amount paid? Knowingly paying more for a stock than its calculated value – in the hope that it can soon be sold for an even higher price – should be labeled speculation (which is neither illegal, nor immoral nor – in our opinion – financially fattening).

Appropriate or not, the term “value investing” is widely used. It usually refers to the purchase of stocks that have characteristics such as a low price-to-book ratio, a low price-to-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from decisive in terms of whether an investor buys something for what it is worth and therefore really operates on the principle of obtaining value in his investments. Accordingly, the opposite characteristics – a high price-to-book ratio, a high price-to-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.

Buffett’s definition of “investing” is the best definition of value investing out there. Value investing is buying stocks for less than their calculated value.

Principles of value investing

1) Each share is an ownership stake in the core business. A stock is not just a piece of paper that can be sold at a higher price in the future. Stocks represent more than just a right to future cash distributions from the company. Economically speaking, each share is an undivided interest in all corporate assets (both tangible and intangible) – and should be valued as such.

2) The share has an intrinsic value. The intrinsic value of the share is derived from the economic value of the underlying business.

3) The stock market is inefficient. Value investors do not accept the efficient market hypothesis. They believe that stocks are often traded at prices above or below their intrinsic value. Occasionally, the difference between the market price of a stock and the intrinsic value of that stock is large enough to allow for profitable investments. Benjamin Graham, the father of value investing, explained the inefficiency of the stock market using a metaphor. His metaphor of Mr. Market is still mentioned by value investors today:

Imagine that you own a small share in a private business that costs you $1,000. One of your partners, named Mr. Market is very kind indeed. Each day he tells you what he thinks your interest is worth and further offers to buy you back or sell you additional interest on that basis. Sometimes his idea of ​​value seems plausible and justified by business development and prospects as you know them. On the other hand, often Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems a little silly to you.

4) Investing is the smartest when it is the most business-like. This is a quote from the book “The Intelligent Investor” by Benjamin Graham. Warren Buffett believes this is the most important investment lesson he has ever received. Investors should treat investments with the same seriousness and studiousness as they treat their chosen profession. An investor should treat the stocks he buys and sells like a trader would treat the commodities he deals with. He must not assume obligations when his knowledge of the “goods” is inadequate. Furthermore, he must not engage in any investment operation unless “reliable calculation shows that it has a fair chance of yielding a reasonable profit.”

5) Real investment requires a margin of safety. A margin of safety can be provided by a company’s working capital position, past earnings results, land assets, economic goodwill, or (most often) a combination of some or all of the above. The margin of safety is reflected in the difference between the stated price and the intrinsic value of the job. It absorbs all the damage caused by the inevitable misjudgments of investors. For this reason, the margin of safety must be as wide as we humans are stupid (which is to say it should be a real chasm). Buying ninety-five cent dollar bills only works if you know what you’re doing; buying dollar bills for forty-five cents will probably prove profitable even to mere mortals like us.

What value investing is not

Value investing is buying stocks for less than their calculated value. Surprisingly, this fact alone separates value investing from most other investment philosophies.

True (long-term) growth investors like Phil Fisher focus exclusively on business value. They don’t care about the price paid, because they only want to buy shares in businesses that are truly outstanding. They believe that the phenomenal growth that such businesses will experience over many years will allow them to benefit from the miracle of compounding. If the value of the business grows fast enough and the stock is held long enough, even a seemingly high price will eventually be justified.

Some so-called value investors consider relative prices. They make decisions based on how the market values ​​other public companies in the same industry and how the market values ​​each dollar of earnings present in all businesses. In other words, they may decide to buy a stock simply because it seems cheap compared to competitors, or because it trades at a lower P/E ratio than the general market, even though the P/E ratio may not seem particularly low in absolute or historical terms.

Should such an approach be called value investing? I don’t think so. That may be a perfectly valid investment philosophy, but it is different investment philosophy.

Value investing requires the calculation of intrinsic value that is independent of the market price. Techniques supported solely (or primarily) on an empirical basis are not part of value investing. The principles established by Graham and expanded upon by others (such as Warren Buffett) form the foundation of a logical structure.

While there may be empirical support for techniques within value investing, Graham has established a school of thought that is very logical. Correct reasoning is emphasized in relation to testable hypotheses; and causal relationships are emphasized over correlative relationships. Value investing can be quantitative; but, it is arithmetically quantitative.

There is a clear (and pervasive) difference between quantitative fields of study that use calculus and quantitative fields of study that remain purely arithmetic.. Value investing treats security analysis as a purely arithmetic field of study. Graham and Buffett were known to have stronger natural mathematical abilities than most security analysts, yet both stated that using more mathematics in security analysis was a mistake. Real value investing requires no more than basic math skills.

Contrarian investing is sometimes considered a sect of value investing. In practice, those who call themselves value investors and those who call themselves contrarians tend to buy very similar stocks.

Consider the case of David Dreman, author of The Contrarian Investor. David Dreman is known as a contrarian investor. In his case, it’s a fitting label, given his keen interest in behavioral finance. However, in most cases the line that separates a value investor from a contrarian investor is fuzzy at best. Dreman’s contrarian investment strategies are derived from three measures: price to earnings, price to cash flow, and price to book value. These same measures are closely related to value investing, and in particular to so-called Graham and Dodd investing (a form of value investing named after Benjamin Graham and David Dodd, co-authors of “Security Analysis”).

Findings

Ultimately, value investing can only be defined as paying less for a stock than its calculated value, where the method used to calculate the stock’s value is truly independent of the stock market. Where intrinsic value is calculated using discounted future cash flow or asset value analysis, the resulting estimate of intrinsic value is independent of the stock market. But a strategy based on simply buying stocks that trade at low price-to-earnings, price-to-book, and price-to-cash-flow multiples relative to other stocks is not value investing. Of course, these very strategies have proven quite effective in the past and will likely continue to work well in the future.

The magic formula devised by Joel Greenblatt is an example of one such effective technique that will often result in portfolios that resemble those built by true value investors. However, Joel Greenblatt’s magic formula does not attempt to calculate the value of the shares purchased. So while the magic formula may be effective, it is not a true value investment. Joel Greenblatt is a value investor himself, as he calculates the intrinsic value of the stocks he buys. Greenblatt wrote The Little Book That Beats the Market for an audience of investors who lacked the ability or inclination to value businesses.

You cannot be a value investor if you are not willing to calculate business values. To be a value investor, you don’t have to value the business precisely – but you do have to value the business.

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