Value investing and financial education is a concept developed by Columbia Business School professors Benjamin Graham and David Dodd in 1934 and this concept popularized by the book, The Intelligent Investor has written by Benjamin Graham in 1949. Value investing supported by prominent investors like Warren Buffett, Charlie Munger, Christopher Browne, Seth Klarman (a billionaire hedge-fund manager), etc. and by many investors around the world.
So let’s understand what is “Value Investing”? As per the concept of Value Investing, investors should always prefer to buy those stocks trading for less than their intrinsic or book value. In simple word, value investing is a process to find those companies/ stocks which as per analysis undervalued at current market price and investing in them to generate good returns.
Many times, market overreacts to the news either good or bad, results in the stock price movements that don’t represent the company’s long-term fundamentals and thus creates an opportunity for profit by buying stocks at a discounted price.The core of the value investing is in estimating the intrinsic value of the stock. After getting the intrinsic value of the stock, one can compare it with the current market price to get the undervalued or overvalued status. If the current market price is less than the intrinsic value, then the stock will be considered as undervalued or vice versa. The value investor always hunts for undervalued stock to get the maximum profit by buying at a discounted price.
“ What the wise man does in the beginning, the fool does in the end. ”
The biggest problem in estimating the intrinsic value is that with the same set of information, two investors can predict different intrinsic value. To overcome this, a value investor should always consider the margin of safety while making the decision. As per the concept of margin of safety, the investor should buy those stocks trading at a big discount. For example, two stocks A and B are trading at Rs 250 & Rs 360 respectively and as per your analysis, intrinsic value for A and B are at Rs 300 and Rs 380 respectively.
In this situation, both A and B are undervalued but stock A is trading at 16.67% [(300-250)/300] discount whereas stock B at 5.26% [(380-360)/380] discount.As per the margin of safety concept, we will invest in stock A as it’s trading at a high discount as compared to stock B.
To calculate the intrinsic value of the stock, we have to analyze different financial statements such as P/L statement, Balance Sheet, Cash flow statement, etc. coupled with the business model, target market, macro & micro factor, etc. Following five fundamental ratios can also be used with the combination of intrinsic value to find the undervalued stocks:
- Price-to-Earnings Ratio (P/E): P/E ratio is calculated by dividing the stock price by its earnings per share. P/E represents the amount investors are willing to pay for each Rs of the company’s earning. A stock with the lower PE ratios cost less per share as compare to the one with higher PE and considered as undervalued (depends on the industry scenario).
- Price-to-Book Value Ratio (P/B): P/B ratio is calculated by dividing the stock price by its book value per share. P/B represents the amount investors are paying for real tangible assets. In general, if the current market price is lower than P/B, the stock considered as undervalued (assuming the company is not in financial hardship).
- Price Earning to growth ratio (PEG Ratio): PEG ratio is calculated by dividing P/E with the annual EPS growth rate. The actual interpretation of PEG varies from industry to industry but as per the thumb rule, PEG less than one indicates the stock is undervalued and above one indicates that the stock is overvalued.
- Debt-to-Equity Ratio (D/E Ratio): The Debt to Equity ratio represents the ratio of debt and equity financing of the co. A higher than industry D/E ratio indicates the negative outlook for the company.
- Free Cash Flow (FCF): Free Cash Flow represents the amount company is generating after capital investment. Sometimes it might possible that company’s net earnings are negative but it might generating significant free cash flow, a positive sign
Value investors need to ask a series of question and to use different metrics in combination before jumping to any conclusion. Detailing with accuracy at each step leads to proper analysis of the stocks and thus creates the opportunity for higher earnings through value investing.