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Value investing is a time-tested investment methodology that consists of estimating a company’s intrinsic value by using a combination of market, financial statement, and macro analysis.
Benjamin Graham is considered the father of value investing after he wrote the book Security Analysis along with David Dodd in 1934 and a sequel called The Intelligent Investor almost 15 years after where he outlined the key principles that describe this method.
Many acclaimed and widely successful investors have followed Graham’s teachings to become prominent value investors including Warren Buffett, Peter Lynch, Bill Ackman, Charlie Munger, and David Einhorn.
In the following article, I’ll explain in detail what value investing is, how it works, which are the most important principles that drive this methodology, and how you can use it to pick potentially undervalued companies in the stock market.
What is Value Investing?
Value investing is an investment methodology that uses financial information provided by companies through their periodical financial statements along with macro and market data to estimate the “fair” or “intrinsic” value of a business.
According to Graham’s definition, an investor in the eyes of the school of value is someone who, upon conducting a thorough analysis of a security, concludes that the operation promises both the safety of the principal and a satisfactory return.
Any operation that falls outside the premises of that definition is considered by Graham speculation.
Therefore, value investing focuses on analyzing the fundamental elements of a business including its profitability, solvency, liquidity, management, and growth to estimate its intrinsic value.
Once that value is calculated, the investor can make a decision based on the market price of the security if there is upside potential and gains to be made as a result of an investment operation.
Pro Tip: Value investing consists of picking stocks that appear to be undervalued. Investors buy and hold these assets with the expectation that the price of the stock will eventually rise, therefore making a profit.
How Does Value Investing Work?
In this section, I’ll dig deeper into the most important concepts of value investing to help the reader in understanding the pillars of this methodology.
The intrinsic value of a stock can be determined by estimating the fair value of the underlying business. For Graham, a stock cannot be analyzed as a piece of paper that is exchanged from one hand to the other.
Instead, a stock has to be valued based on the prospects of the underlying business, which in this case is the company that issues the instrument.
To estimate the fair value of a business, value investors interpret the information contained in the company’s financial statements and draft multiple ratios and indicators that provide information about the evolution of the company’s earnings, solvency, liquidity, and growth.
These metrics are classified as follows:
- Growth: annual revenue growth (total or per segment), earnings growth, EBITDA growth.
- Profitability: profit margins, return on equity (ROE), return on assets (ROA), return on capital invested (ROIC), EBITDA margin, etc.
- Liquidity: quick ratio, acid test, inventory turnover, cash cycle, free cash flow, etc.
- Solvency: debt-to-assets ratio, debt-to-equity ratio, interest coverage ratio, etc.
- Efficiency: inventory turnover, asset turnover ratio, etc.
- Valuation: price-to-earnings (P/E) ratio, price-to-cash-flow (P/FCF), EV/EBITDA, etc.
Additionally, investors can employ financial statement analysis techniques such as vertical and horizontal analysis to evaluate the performance of the business during a certain accounting cycle (vertical) or the evolution of different accounts throughout multiple periods (horizontal).
Once these metrics have been analyzed, investors will aim to estimate the company’s future earnings generation capacity and will usually employ multiples like the price-to-earnings ratio to estimate the fair value of the company.
These estimates are drafted based on an objective assessment of the business track record and growth prospects while the valuation multiple is commonly assigned based on the quality of the business and multiple other quantitative and qualitative factors.
Margin of Safety
Value investing is not considered a perfect science as it involves significant guesswork when it comes to estimating a firm’s future performance since investors rely on past performance to calculate future earnings and growth.
That being the case, the margin of safety principle was introduced by Graham as a way to permit some degree of human error when estimating the value of a company. This principle is quite simple and it consists of buying a company only if it is trading at least two-thirds below its intrinsic value.
If the company can be bought at such a price, it would mean that even if the investor’s estimations were too optimistic, the purchase price would still be low enough to allow for such an error without causing the investor a loss.
Warren Buffett once said that buying a $1 company with a margin of safety of 50%, for example, would be a transaction similar to buying a dollar for 50 cents.
Pro Tip: Margin of safety is based on the premise that buying stocks at bargain prices gives investors a better chance at earning a profit later when they sell them. In other words, these stocks have plenty of upside potential.
Value investing assumes that the market is not as efficient as some theoretical models seem to suggest. This view goes against the popular efficient market hypothesis (EMH), which assumes that all actors within the marketplace act rationally and that all public information is immediately incorporated into the price of a security.
In this regard, value investors believe that markets act irrationally at times. For example, during instances of economic hardship or extreme uncertainty, market participants might feel overly pessimistic about the future and will react accordingly by selling the stock of companies they own at prices that could be below the intrinsic value of the business. In turn, the opposite occurs during times of extreme greed, when market participants might be willing to pay any price for a business regardless of its fundamentals.
In the book The Intelligent Investor, Graham illustrates this belief by using a character known as Mr. Market. This character portraits how the market behaves every day, presenting the investor with a price for each of the securities listed. Some days, Mr. Market feels overly pessimistic and offers a low price. Meanwhile, on other occasions, Mr. Market will feel overly confident and raise the price to a point that it exceeds the fair value of the business.
Value investors understand and take advantage of market inefficiencies by buying securities when Mr. Market offers them below their intrinsic value while they might decide to sell if Mr. Market offers a price that is well above their most optimistic fair value estimates.
Ignore The Herd
Warren Buffett, the Chief Executive Officer of Berkshire Hathaway and a very successful follower of the value investing methodology, once said that investors should be “fearful when others are greedy and greedy when others are fearful”.
This means that value investors are contrarians by nature as they will buy when everybody is selling and sell when everybody is buying.
This is an important aspect of value investing that involves a good deal of mental control as one can easily become a pessimist when everybody is selling and the market as a whole is falling off a cliff.
By buying at low prices when “there is blood on the streets”, value investors can purchase high-quality businesses at a fraction of their intrinsic value while they should progressively profit once market sentiments start to pick up.
Invest for the Long Term
Even though Graham’s initial approach to value investing involved identifying businesses that traded below their intrinsic value to then sell them at a profit once the market moved back to the green, value investing has evolved to become a long-term investment methodology.
In this regard, it is important to note that market prices can stay irrational for a long time, which means that a business can trade below its intrinsic value for years before the market catches up.
Therefore, a value investor focuses on the long term instead of being distracted by the noise made by the media, analysts, or economists as a result of the market’s short-term swings.
Value investors expect that stock prices will eventually revert near the fair price as estimated by the fundamentals of the underlying business, at which point they will stand to make a profit from their investment. Therefore, patience is a much-needed virtue for value investors.
Understand The Business
The best value investors focus only on businesses they can understand. This means that they can easily explain how the business model functions, how the company makes money, which factors affect the demand for its services, and how its expenses could be affected by changes in the macro landscape. In summary, it means that the investor understands the economics of the business.
Since value investing involves analyzing a company’s fundamental metrics, investors must understand who the business works since otherwise it would be impossible to make an informed estimation of how much it is worth.
In this regard, being a value investor doesn’t necessarily mean that one has to understand every business. Instead, it is often a good idea to invest in companies that are familiar to the investor because of his/her academic background, experience, and knowledge.
Pro Tip: “Never invest in a business you cannot understand.” — Warren Buffett
Avoid Value Traps
Investing in a company that seems cheap after performing a fundamental analysis of the business is not necessarily value investing. This type of company is known as a “value trap” as even though the intrinsic value of the business might be higher than the current market price, the quality of the company and its growth prospects are not good enough and that is the reason why the market seems to be undervaluing the business.
Value traps are a risk to value investors and the best way to avoid them is to find companies that have a competitive “moat”. A moat in the context of value investing is a strong and long-lasting competitive advantage that others can’t easily replicate.
That moat can be a widely recognized brand, a leading position in the marketplace, a patent, or even an incredible corporate culture. Take for example, Disney. The company has been for years a reference for tourists around the world due to its iconic characters, magical experiences, and entertaining theme parks.
It would be very difficult for another company to replicate Disney’s business model as that would take a significant amount of resources and, even if those are available, it would be very difficult to position a brand at the place that Disney is. That is the definition of a moat.
The best businesses for value investors are those that have a big moat as they will be able to keep delivering the kind of results seen in the past for a long time.
As explained earlier in the article, Benjamin Graham defined investing as an operation that offered both the safety of the principal and an adequate return. To put this into context, an adequate return is one that satisfies the risk assumed by the investor.
That risk is, based on Graham’s definition, is not related to the potential loss of principal — a scenario that should be off the table for value investors — but to a percentage of return that is higher than that offered by low-risk securities.
Nowadays, investors use models like the Capital Asset Pricing Model (CAPM) to calculate a suitable rate of return for an investment based on the risk-free rate of return, often defined as the yield of the 10-year US Treasury bond, and risk factors such as the stock’s beta.
However, old-school value investors tend to use the average historical return offered by index funds like those that track the S&P 500 while they will seek to identify companies that are well-capitalized and whose returns are better than those offered by the S&P 500.
Pro Tip: “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” — Benjamin Graham
Benefits of Value Investing (Pros)
- It is a time-tested investment methodology that relies on objective data to determine the value of a business.
- It is considered a low-risk strategy as its primary objective is to assure the safety of the principal invested.
- Over long periods, the United States market has always gone up which makes value investing a “trend-following” methodology. This increases the likelihood of producing positive results over time.
- It leverages on compounding to produce outstanding returns for long-term investors.
- Investors will save money on trading fees by reducing their portfolio turnover as value investing is a buy-and-hold strategy.
Downsides of Value Investing (Cons)
- It requires extensive accounting and financial knowledge for the interpretation of financial statements.
- Investors must be patient as it could take time for the market to return to the fundamentals when a stock has been mispriced.
- Estimating the fair or intrinsic value of a stock can be difficult and requires some degree of guesswork.
Who Should Be a Value Investor?
Even though there are many advantages to adopting value investing as your investment methodology, investors need to consider multiple variables before choosing this approach when building a portfolio.
The first variable to take into account is your investment horizon. This refers to the amount of time that investors are willing to wait for their stock picks to start delivering the results they expect.
Since value investing is a long-term strategy, investors who need to produce income for their living expenses might not find this approach suitable to their needs.
Additionally, since value investing demands a fair share of financial analysis, investors who don’t have a business, accounting, or finance background might find it difficult to interpret financial statements unless they are properly trained.
Finally, for those who enjoy trading, value investing might not be the right methodology to follow as stocks trading below their intrinsic value can remain at those levels for long periods before the market realizes the gap and re-prices the instrument accordingly.
FAQs on Value Investing
The following are answers to some of the most frequent questions we get from our readers on the topic of value investing.
Is Warren Buffett a Value Investor?
Yes. Warren Buffett is one of the most successful value investors in history, having produced a compounded annual return of 20% from 1965 to 2020 including dividends. He has achieved this through his company Berkshire Hathaway, a conglomerate that invests in multiple businesses and segments of the economy including insurance, technology, chemicals, energy, financial companies, and restaurants.
Buffett was a student of Benjamin Graham and he even went to work for him for a while. However, he contributed a fair deal to enhancing Graham’s techniques by incorporating multiple important approaches to the discipline of value investing. Some of those were mentioned earlier in this article including the importance of investing in businesses one understands and buying when everybody is selling.
Does Value Investing Really Work?
Value investing is a time-tested investment methodology that has delivered positive results to those who have the discipline to follow its core principles. One key aspect of value investing is having the patience required to wait until an undervalued business is re-priced by the market.
Some investors who follow this methodology and fail don’t often do so because they don’t have the skills to adequately value a company. They fail because they don’t have the patience to wait until the market realizes its mistakes and corrects them accordingly.
What is Benjamin Graham’s Investment Strategy?
Benjamin Graham’s investment strategy initially consisted of buying businesses that traded below their liquidation or book value upon conducting a thorough analysis of the combined value of their tangible and intangible assets.
Graham called this approach “finding the net-nets”, which meant identifying companies that were trading below the value resulting from subtracting the business total liabilities from the liquidation value of its assets.
However, that strategy evolved with the introduction of The Intelligent Investor as Graham started to focus on finding businesses that were undervalued not just based on their liquidation value but also on their historical and future earnings generation capacity as indicated by ratios like the price-to-earnings (P/E) and price-to-cash flow (P/FCF) ratios.
What is the Difference Between Value Investing and Growth Investing?
Growth investing has emerged in recent decades in response to the positive performance that companies whose fundamentals were not as good as Graham’s approach but that either way turned out to be great businesses due to their disruptive nature, innovative approach, incredible growth, and huge total addressable markets.
Different from value investors, growth investors seek to identify companies during the early stages of their development that are already displaying elevated growth rates. They should also be quickly surpassing their competitors in terms of innovation, consumer adoption, brand awareness, and other qualitative factors.
Even though growth companies might not be as financially sound or profitable as value picks, they will eventually turn out to be great value investments once they position themselves as the leaders of their respective markets.
Is Value Investing Different Than Speculation?
Yes. According to Graham, only investments that can promise the safety of the principle and an adequate rate of return can be considered as such. Any operation that does not meet this criterion should be considered speculation.
Speculating in the stock market does not require a thorough assessment of a business fundamentals. Instead, those who wish to speculate may follow different approaches that could involve a technical assessment of the price action of a stock or an analysis of the macroeconomic environment to “time” the market.
What Are Common Value Investing Metrics?
Among the most common metrics used by value investors we can name the following:
- Profit margins (gross, EBITDA, operating, and net margins).
- Return on equity (ROE).
- Return on Invested Capital (ROIC).
- Free Cash Flow.
- Debt-to-Equity (D/E).
- Debt-to-Assets (D/A).
- Interest coverage ratio.
- 5-year average earnings growth.
- 5-year average revenue growth.
- Price-to-earnings (P/E) ratio.
- Price-to-free-cash-flow (P/FCF) ratio.
- Price-to-earnings-to-growth (PEG) ratio.
Why Stocks Become Undervalued or Overvalued?
Even though proponents of the efficient market hypothesis (EMH) believe that distortions in the stock market’s pricing mechanisms do not occur, value investing has proven otherwise for decades as reflected by the returns that some individual investors have managed to generate by following this approach.
The reasons behind these temporary distortions include emotional decisions made by market participants during times of extreme pessimism or extreme optimism, different perspectives about the future of a certain company, and unexpected macro developments.
Now that you know how value investing works, you can decide if this is the methodology you would like to adopt for building a portfolio based on your financial goals.
We have probably just scratched the surface of how value investing works in this article. So, if you are interested in learning more about this method you could read Benjamin Graham’s two books — Security Analysis and The Intelligent Investor — and many others that have been written by those who have followed his teachings over the years and who have successfully implemented it.
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Alejandro is a financial writer with 7 years of experience in financial management and financial analysis. He writes technical content about economics, finance, investments, and real estate and has also assisted financial businesses in building their digital marketing strategy. His favorite topics are value investing and financial analysis.