Value investing is an investing strategy created by Ben Graham and David Dodd. The two taught this investing strategy at the Columbia Business School. Value investing has gotten a lot of attention since Warren Buffett, one of the most successful and most recognized investor on Wall Street, was a student and a dedicated follower of this approach.
Value investing involves buying securities whose price is undervalued and trading below its fair value. This is done by buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Value investors buy a stock whose intrinsic value is below the current market price and bet that the price will eventually revert back to its fair value.
The idea behind value investing is that all equities eventually regress back to its mean. Value investors buy financially sound equities if their price is trading at a substantial discount. Graham called this discount a margin of safety.
Markets are volatile and stock prices fluctuate for a number of different reason. A negative headline in newspaper, a bad quarter, or a small scandal is all factors affecting a companyâs stock price. As long as these events do not permanently damage the companyâs long term viability a value investor may consider investing in the company.
Value investors buy a company when its stock price is low. They then hold on to the stock for as long as it takes for the stock to recover.
Markets are very harsh and unforgiving. The market often over punish a company for a small blunder and sends it stock price far below what it deserves be priced at based on its fundamental values. Just like people companies make mistakes. A mistake may cause a company to lose half of its value in market capitalization (share price x outstanding shares) but the company still has its assets, equipment, expertise, customer base, brand name, etc. Value investors know a temporary drop in price as an opportunity to acquire a good company at a discount.
How do I know what to pay for a stock?
Here are a few methods value investors use to calculate valueâ¦
1. Look for companies with a low P/E ratio.
The price to earnings ratio P/E ratio (also known as earnings multiple) tells you how much you are paying for the companyâs current earnings. The higher the P/E ratio the more you are paying for earnings. A high P/E ratio indicates that the company is expected to grow at a higher rate and that you will pay a premium for those higher earnings. A high P/E ratio may also mean that the company is overvalued. If it seems unlikely that the company will continue to grow at the estimated rate the company is probably overvalued.
A low P/E ratio may be a sign that the company is inexpensive. A bad quarter or a stock market selloff may decrease the companyâs P/E ratio and create a buying opportunity.
The P/E ratio is a good method of comparing the price of two companies. If the two companies operate in the same industries and are equally competitive and equally financially stable you can quickly see which company is more or less expensive.
2. Low Price/Earnings to Growth (PEG)
Price/Earnings to Growth (PEG). Formula: P/E Ratio / Annual EPS Growth. PEG is used by many value investors to value companies. A lower PEG ratio means that you are paying less for future earnings growth. A bargain stock typically has a PEG below one. Keep in mind that the PEG is only as good as the forecasted earnings. If the earnings growth is wrong the formula will be wrong.
3. Low Price to Book Ratio (P/B Ratio)
Price to Book Ratio (P/B Ratio). Formula (Share outstanding x stock price) / (Tangible assets â Intangible assets â liabilities). A low P/B Ratio might mean that the company is undervalued. It is good tool for comparing two companies.
Mr. Marketâ¦
To make sense out of the market Ben Graham created a game he called Mr. Market.
He referred to Mr. Market as his emotionally disturbed friend. Mr. Marketâs mood would drastically swing up and down from day to day. One day Mr. Market would be extremely optimistic. He would consider the world as a wonderful and positive place where things could only get better. As a result he would quote you a very high price on that particular day.
On another day Mr. Market would be in a terrible mood. He would be angry, emotional, and very unhappy! Mr. Market would say that things would only get worse from now on. And as a result of his pessimistic forecast he would quote you an incredibly low price.
Mr. Market would however show up every day with a new quote and the price would depend on his mood at the time.
Ben Graham understood Mr. Marketâs unstable and emotional state of mind. Graham knew that Mr. Market would continue to show up with a new quote everyday regardless of his mood. With this knowledge in mind Graham and every other value investors would simply wait for Mr. Market to be in his worst kind of moods before buying.