What is value investing?What is value investing?

The value investing strategy was popularised by American economist Benjamin Graham, and high-profile investors like Warren Buffett and Charlie Munger.

What’s value investing?

Value investors try to estimate a company’s intrinsic value (how much they think the company’s worth) and compare that to its market value (current share price). 

If they think the company is worth more than its market value, they consider it to be ‘undervalued’ (priced too low in the market) and would look to invest in the company based on the belief that the share price will eventually rise to its intrinsic value.

For example, let’s say that a company’s current share price is $10. An investor might analyse the company and think it’s actually worth between $13 and $15 per share. Under the value investing approach, the investor might buy shares in the company, hoping to profit if the share price rises (as a result of the wider market realising that the company might have been undervalued).

Value investors believe that investing should be viewed as buying a business, not buying shares. They believe that share markets can overreact to good and bad news, creating opportunities to invest in companies for a good value, or ‘at a discount’.

What is value?

Shares have value because it gives investors a slice of ownership in a company—they get to benefit if the company does well, makes profits, and grows in value or pays dividends. Investors are willing to pay a price now for the potential to receive a portion of the company’s future share value as it grows, or profits if distributed as dividends.  

Investors do their own analysis to estimate the size of the potential future share value or dividends the company may pay, when this might occur, and what risks are involved. This helps to decide how much they think the company and its shares are currently worth—in other words, its intrinsic value. 

Intrinsic value is an educated guess. Investors will have different views on the future of the company and will reach different conclusions. This difference in views all helps form the supply and demand that determines the market price of a share.

How do you estimate the value of a company?

There’s no easy way around estimating the intrinsic value of a company—it usually requires a fair bit of homework. A value investor might start by taking a view on the company’s future, including:

• Analysing the company’s publicly available financials, such as its revenue, profits, and cash flows.

• Looking at the company’s business model, strategy, and growth prospects.

• Comparing the company with its competitors, including its brand, competitive advantage, and market share.

• Evaluating the risks to the company and how these might impact the business and its financials.

Then, use these views to calculate an estimate of intrinsic value. This could involve using a financial model, such as: 

• The Dividend Discount Model—investors use their views on the company’s future to estimate how much it’ll pay in future dividends (adjusted for the fact that the investment is being made today), and then add these up to calculate the estimated intrinsic value per share.

• The Discounted Cash Flow Model—investors estimate the future cash flows that they expect the company to make (adjusted to what they would be worth today), and then add these up to calculate the estimated intrinsic value per share. 

Both of these methods require using mathematical calculations and making assumptions about the future growth and risks of the company, which can make them complex to use. 

There’s also the risk that any forecasts may differ from what actually happens to the company—after all, nobody can perfectly predict the future. Because of this, value investors often look at multiple scenarios for their forecasts, and calculate a value range for a company instead of landing on a single number.

An alternative approach

A similar but simpler approach is one based on the Law of One Price. This strategy assumes that two similar investments should be priced similarly. Investors using this strategy compare the company’s financial ratios to similar companies in the same industry. They look for companies with comparable business models, geographies, sizes, and growth rates. The more comparable the companies are, the closer the comparison that can be made.

Value investors look for companies that have lower financial ratios compared to similar companies, as this could indicate that the company is ‘undervalued’ relative to others. Some of these ratios include:

• Price-to-earnings (P/E)—a company’s current share price divided by its earnings per share.

• Price-to-book (P/B)—a company’s market capitalisation compared to its book value (the value of the company’s assets minus its liabilities).

• Price-to-sales (P/S)—a company’s current market capitalisation divided by its total sales (or revenue) for a period. 

• Price-to-cash flow (P/CF)—a company’s market capitalisation divided by its operating cash flow for a period.

You can find the info you need to calculate these ratios in a company’s latest annual report or on the relevant exchange’s website. 

After they’ve compared the ratios, a value investor will dig into the details and ask if there’s any valid reason why a company might have a lower ratio than its peers.

“Outsource” it to the professionals

If you’re interested in trying out this investing strategy but aren’t keen on doing the analysis yourself, there are also fund managers and exchange-traded funds (ETFs) that specialise in value investing. You can find these by reading the fund manager’s description, or searching for funds with “value” in their name on Sharesies (although not every fund with “value” in their name uses the value investing strategy)—have a look and see if these might be right for you.

Considerations

Regardless of which method is used to estimate value, value investors need to do due diligence and be aware of ‘value trap’ companies. This is when a company might look like a good value investment, but in reality, may be facing financial troubles or have little growth potential due to long-term or more permanent factors. The company may be facing increased competition, management issues, disruptive technologies, or something else entirely. In other words, it might be ‘undervalued’ or ‘cheap’ for a reason.

Ultimately, intrinsic value is an estimated and subjective measure—it’s based on the investor’s own assumptions, analysis, and opinions about a company. This means that there’s always the chance that either a) they’re wrong, or b) they’re right, but the market is wrong. Because value investors need the company’s share price to rise in order for their strategy to be successful, it’s possible that it might take a long time to happen, or even not happen at all.

One way to help manage this risk might be to invest in companies that have a current share price that’s significantly lower than the estimated intrinsic value. Known as a ‘margin of safety’, this helps to build some room for error in the estimates used to calculate intrinsic value, bad luck, or unforeseen events.

Wrapping up

Value investing is just one of the many investing strategies you can choose from. There are lots of other strategies based on different beliefs, such as growth investing, dividend investing, momentum investing, or growth at a reasonable price (GARP) investing. There’s no one-size-fits-all approach, so it’s all about figuring out what works best for you and your financial situation and goals.