Value investing is the most popular strategy in equity investing. Value investing is the strategy that Warren Buffet used to become the richest person on the planet. Aside from him, Benjamin Graham, David Dodd, William J. Ruane, Irving Kahn, Walter Schloss, and Charlie Munger are some of the names who gained huge success by following the principles of Value Investing. Not only that, value investing has helped countless retail investors to amass millions. In this article, we will discuss the basics of value investing and how it can help you to earn money from stock markets.
The concept behind value investing
The concept of value investing was first given by Benjamin Graham and David Dodd in 1934. It was popularized in Graham’s 1949 book, The Intelligent Investor. In fact, Warren Buffet was also a student of Benjamin Graham. Value investors depend on fundamental analysis to identify profitable stocks which means to analyze a stock or a company in order to find what it should be worth by examining various underlying factors.
The idea behind value investing is simple. If you know the real value of something and can manage to buy it at a discount, i.e., at a price less than its true value, then you just made a profitable deal. Value investing works in a similar fashion. First, identify the real value of companies with fundamental analysis and invest only in those companies whose stock prices are less than their intrinsic value.
In other words, you have to look for stocks that are trading at a discount to their intrinsic value so that you can resell them at higher prices when the market corrects its mistake and stock begins to trade at its fair value. For example, you perform a fundamental analysis of a company and conclude that its intrinsic value is $50 per share. Now you compare the intrinsic value with the market price of stock. If it is equal to or above the intrinsic value, it is not a good investment option. But if the market price is below the intrinsic value, let’s say $35, then it can be a good stock to invest in.
Value investors invest in stocks that they believe that the market has undervalued with the assumption that the market will eventually correct its error in valuation. They are just like those frugal shoppers who are always in search of offers and sales and want to buy everything at a discount or bargain.
Identifying the Intrinsic Value
Value investing sounds simple and easy but the success in value investing boils down to the accuracy with one can determine a company’s intrinsic value. There is no single-best method to calculate the fair value of a stock. Investors use various quantitative and qualitative measures such as financial statements, cash flow, price-to-book (P/B) ratio, price-to-earnings (P/E) ratio, business model, the competence of management, business environment, etc., to estimate the intrinsic value of a company. Then they compare it to the market price to decide if the stock is a good bargain or not.
While doing this, most investors always consider the margin of safety. It means that they consider buying a stock only when there is a significant difference between market price and intrinsic value. This simply provides a cushion against errors in analysis or calculation and reduces downside risk. For example, Benjamin Graham always recommended buying only those stocks that were priced at two-thirds or less of their intrinsic value.
Value Investing works. This is evident not only by the performance of successful value investors but various studies have also shown that it can beat markets in the long run. However, successful value investing is not that easy. It requires a lot of courage to do exactly the opposite of what everyone else is doing as value investors buy when everyone else sells and sell when others buy. Apart from that, it also requires a great deal of knowledge, practice, hard work and patience to master the art of value investing.
Author: Harsh Agarwal
Harsh Agarwal is an investor, trader, and entrepreneur. He was always curious about the world of investing and finance. He started trading and investing in the markets at the age of 16. To him investing is not only about making money but a way of living a fulfilled life. Harsh believes that more and more people should learn the art of investing so that there are more happy faces on this planet. He has helped countless newbies to get started on the path of investing. He occasionally writes for Trading Tuitions and is the author of the course An Ultimate Guide to Successful Investing.