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Value investing was an investment strategy used by one of the greatest investors of our time, Warren Buffet.
As a long time fan and loyal follower, I want to share with you today everything that you need to know about value investing.
What Is Value Investing?
Value investing is an investment strategy where you buy stocks for less than their intrinsic value. In other words, you will be looking for undervalued stocks to buy.
3 Essential Terms In Value Investing
What Is Intrinsic Value?
According to Investopedia, here is the definition of intrinsic value:
“The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors.”
To put it simply, we need to find both the tangible value and intangible value of a business to arrive at its intrinsic value.
What Is Margin Of Safety?
Margin of safety is another important concept in value investing.
Margin Of Safety = Intrinsic Value – Market Price
The difference between the intrinsic value and the market price is margin of safety.
What it means is that investors will only buy the stock when the market price is significantly below its intrinsic value.
A high margin of safety offers more protection and higher returns.
What Is Economic Moat?
Economic moat refers to a business’ ability to have sustainable competitive advantage over its competitors. So, it will enjoy higher profits over its competitors in the long term.
A typical example of a competitive advantage is a low cost advantage.
Due to its size and retailer strength, Walmart can undercut most of its competitors by offering a wide selection and low price.
Companies can develop a competitive advantage through product/service differentiation as well.
This can happen only when the company has a value and unique offering that its customers want and cannot get it from somewhere else.
For example, Rolex differentiates itself by having a value brand. Amazon Prime uses speed as its competitive advantage.
How To Find Undervalued Stocks
So, how do you find undervalued stocks to invest in?
Before you do that, you need to understand first why stocks become undervalued and mis-priced.
Here is how stocks can get oversold and undervalued:
- Market Crash
Back in 2008 market crash, we saw that stock prices fell significantly across the board. Everyone was selling out of fear, even the shares of good and fundamentally sound companies. It’s irrational behavior like this that gives value investors opportunities to snatch up good companies at very cheap price.
- Bad News
Bad news can happen.
But, not all bad news can affect the business in a fundamental way.
Mostly, this is just a one-time event that might temporarily hurt the business performance for that year.
However, some people forget to use their common sense and would start to sell their shares out of fear until the stock becomes oversold.
Here’s a three-step approach to find undervalued stock:
Step 1: Identify a list of companies based on your criteria
You should always invest in businesses that you know.
When you buy stocks of companies that you know nothing about, you have a good chance to make a loss on your investments.
First, you probably won’t know whether you are overpaying for the stock.
Second, when the stock price goes down, you probably won’t know whether you should keep holding it or cut loss.
So, how do we select companies that we could potentially invest in?
Identify what industry that you have good knowledge of.
Next, filter out the companies based on your pre-determined criteria.
For example, you might be only interested in buying large cap stocks.
Based on your criteria, you will have a list of large cap stocks from the industry of your choice.
Step 2: Look at the financials
(1) Price-To-Earnings (PE) Ratio
PE ratio is calculated by dividing the market price by the average earnings per share.
If the PE ratio is 20, that means that you are paying 20 times the earnings for the stock.
To put it more simply, you are paying $20 for each dollar you get in return.
So, the higher the PE ratio, the higher the cost to get the same return.
Ideally, we will want to pay less to get the same return on our investment. So, value investors look for companies with a PE ratio at least less than 20.
(2) Price-to-Book (PB) Ratio
PB ratio is book value(i.e. net assets) of the company by the market price.
It indicates how much investors are willing to pay for the net assets of the company.
Because net asset value does not include any intangible assets such as patents, copyrights, trademarks, brand recognition and etc, PB ratio is very conservative financial ratio.
For companies with significant intangibles, PB ratio will not be a reliable metric.
So, how value investors can make use of Price-to-Book ratio?
Generally, a low Price-to-Book ratio is a good indicator for value investors. It could mean that the company is undervalued.
(3) Debt-Equity Ratio
Debt-to-Equity ratio can give you a good idea about how leveraged the company is.
If the ratio is high, that means the company takes on a lot of debt to finance its assets.
Lower Debt-to-Equity ratio is more favored for value investors because it can indicate that the company is quite prudent when it comes to its debt financing.
As some industries tend to have high Debt-to-Equity ratio, you should compare it against the industry average Debt-to-Equity ratio to determine whether or not it’s too high.
(4) Free Cash Flow
While it’s relatively easier to manipulate a company’s earnings, it’s not so easy to manipulate its cash flow.
To see if a company is doing well financially, you just need to find out whether or not the company has a positive cash flow.
In other words, does the company have greater cash inflow than cash outflow?
If yes, then it has a positive cash flow.
If no, then it has a negative cash flow.
Positive cash flow allows the company to stay afloat. Negative cash flow indicates the company is struggling financially.
To give you an analogy, if your monthly expense is always greater than your monthly income, you will be gradually depleting your savings until you run out of money.
Does that paint a very good picture of your financial future?
The same goes for businesses with consistent negative cash flow.
For value investors, we only want to invest in businesses that generate positive cash flow consistently.
(5) Price/Earning to Growth ratio
Price/Earning to Growth ratio is Price-to-Earning ratio divided by company growth rate.
Generally, Price-to-Earning ratio is higher for companies with higher growth rate because investors are willing to pay more for higher growth rate.
So, how do we use PEG ratio in value investing?
Generally speaking, if PEG ratio is higher than 1, then it could mean that stock is overvalued.
Conversely, if PEG ratio is less than 1, then it could indicate the stock is undervalued.
Step 3: Look beyond the financial ratios
Now, that you have probably made a shortlist of companies based on the financial ratios.
But looking at financial ratio alone is not enough.
For example, a company in a sunset industry could have low PE and PB ratio. But you won’t want to invest in this company because there’s no future growth.
So, we need to look at the future growth of the companies as well.
Before you invest in the company, ask yourself these questions:
- How strongly do you believe in their growth story?
- What are they doing to grow the business?
- What is their growth strategy?
- How is the strategy working out?
- How likely will the company keep its promise about future growth?
What Does It Take To Be A Good Value Investor?
Discipline and patience.
It sounds simple. But, a lot of people find it difficult to put it into practice.
Here’s what happens in real life.
You stick to value investing strategy consistently – only buy stocks for less than their intrinsic value.
Consistency requires a lot of discipline.
What is discipline?
When most of your friends are rushing to buy a hot tech stock, you don’t follow the herd.
When everyone is asking you to get into bitcoin, you ignore their call.
You are only looking for stocks that have been oversold and are undervalued.
But, discipline is not enough.
Because good buying opportunities don’t come so often. You will need to have the patience to wait until the time is right.
Here’s Warren Buffet’s quote:
“I call investing the greatest business in the world … because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.”
It perfectly illustrates the point.
You don’t have to swing at every pitch. You just sit there and watch pitch after pitch go by and wait for the one right in your sweet spot.
Recommended Resources To Help You Find Good Stock Ideas
So, to make money from the stock market, you first need to know what good stocks you can invest in.
But, no one can possibly scan the entire stock market for good investment opportunities because you simply don’t have the time. (by the way, there are close to 4,000 stocks listed on US stock exchanges alone)
Also, there are always other people who have more knowledge and experience in a particular industry than you, so you would probably miss some great stock ideas that are hard to discover on your own.
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