Advantage Of A Discounted Cash Flow Method Of Analysis What is Value Investing?

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What is Value Investing?

What is value investing?

Different sources define value investing differently. Some argue that value investing is an investment philosophy that favors buying stocks that currently sell at low price-to-book ratios and have high dividend yields. Others say that value investing means buying stocks with low P/E ratios. You’ll sometimes hear that value investing has more to do with the balance sheet than the income statement.

In a 1992 letter to Berkshire Hathaway shareholders, Warren Buffett wrote:

We think the term “value investing” is meaningless. What is an “investment” if it is not the act of finding at least enough value to justify the payment? Deliberately paying more for a stock than its measured value – in the hope that it can soon be sold at a higher price – should be labeled as speculation (which is illegal, unethical or – in our view – not financially sound).

Fairly or not, the term “value investing” is thrown around a lot. Typically, this refers to the purchase of stocks with attributes such as a low price-to-book value ratio, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear together, are far from determining whether the investor is really buying something for its value and therefore works on the principle of actually getting value in his investment. Accordingly, the opposite characteristics—high price-to-book value ratios, high price-to-earnings ratios, and low dividend yields—are by no means inconsistent with a “value” purchase.

Buffett’s definition of “investment” is the best definition of value investing. Value investing is buying a stock for less than its assessed value.

Principles of Value Investing

1) Each share of stock is an ownership interest in the underlying business. A stock is not just a piece of paper that can be sold at a higher price at some future date. Stocks represent more than the right to receive future cash distributions from a business. Financially, each share is an undivided interest in all corporate assets (both tangible and intangible) – and must be valued as such.

2) Stocks have intrinsic value. The intrinsic value of a stock is derived from the economic value of the underlying business.

3) The stock market is inefficient. Value investors do not subscribe to the efficient market hypothesis. They believe that stocks frequently trade at prices above or below their intrinsic values. Sometimes, the difference between a stock’s market price and that stock’s intrinsic value is wide enough to allow a profitable investment. Benjamin Graham, the father of value investing, used a metaphor to explain the inefficiency of the stock market. His Mr. Market metaphor is still referenced today by value investors:

Imagine that you own a small stake in some private business that costs you $1,000. One of your partners named Mr. Market is very obliging indeed. Every day he tells you what he thinks you’re interested in and offers to either buy you or sell you additional interest based on that. Sometimes his idea of ​​value seems plausible and justified as you know it by business developments and prospects. Too often, on the other hand, Mr. Market lets his enthusiasm or his fear run away with him, and the value he proposes strikes you as a little silly.

4) Investing is smartest when it’s like a business. This is a quote from “The Intelligent Investor” by Benjamin Graham. Warren Buffett believes this is the single most important investment lesson he was ever taught. Investors should approach their chosen business with the same seriousness and diligence that investment deals should. An investor should treat the shares he buys and sells like a shopkeeper who buys them. Moreover, he should not engage in any investment operation unless “reliable calculations show that there is a reasonable chance of making a reasonable profit”.

5) True investment requires a margin of safety. A margin of safety may be provided by the firm’s working capital position, past earnings performance, land assets, financial goodwill, or (most commonly) a combination of some or all of the above. The margin of safety is expressed as the difference between the quoted price and the intrinsic value of the business. It absorbs all losses due to inevitable miscalculations by the investor. For this reason, the margin of safety must be as wide as we humans are stupid (ie it must be a real gap). Buying dollar bills for ninety-five cents only works if you know what you’re doing; Buying dollar bills for forty-five cents is likely to be profitable even for mere mortals like us.

What a value investment

Value investing is buying a stock for less than its assessed value. Surprisingly, this fact alone distinguishes value investing from other investment philosophies.

True (long-term) growth investors like Phil Fisher focus solely on business value. They don’t concern themselves with the price they pay, because they only want to buy shares in businesses that are truly exceptional. He believes that the unprecedented growth of such businesses over the years will allow them to take advantage of the wonders of compounding. If the value of the business grows rapidly and the stock is held long enough, even a seemingly high price will ultimately be justified.

Some so-called value investors consider relative prices. They make decisions based on how the market is valuing other public companies in the same industry and how the market is valuing each dollar of earnings present in all businesses. In other words, they may choose to buy a stock because it looks cheap relative to its peers, or because it’s trading at a low P/E ratio relative to the general market even though the P/E ratio doesn’t look particularly low. In absolute or historical terms.

Should such a practice be called value investing? I don’t think so. This may be a perfectly valid investment philosophy, but it is different Investment philosophy.

Value investing requires calculating intrinsic value independent of market price. Techniques supported solely (or primarily) on an empirical basis are not part of value investing. The theories laid out by Graham and expanded by others (such as Warren Buffett) form the foundation of a logical building.

Although there may be empirical support for value investing techniques, Graham established a school of thought that is highly logical. Emphasis is placed on sound reasoning over verifiable hypotheses; And causal relationships are stressed over correlations. Value investing can be quantitative; But, it is arithmetically quantitative.

There is a clear (and broad) distinction between quantitative fields of study that use calculus and quantitative fields of study that remain purely arithmetic.. Value investing considers security analysis a purely arithmetical field of study. Both Graham and Buffett were known for having stronger natural mathematical abilities than most security analysts, and yet both stated that the use of higher mathematics in security analysis was a mistake. True value investing requires no more than basic math skills.

Contrarian investing is sometimes thought of as a cult of value investing. In practice, those who call themselves investors and those who call themselves contrarian investors buy the same shares.

Consider the case of David Drayman, author of “The Contrarian Investor.” David Drayman is known as a contrarian investor. In his case, it’s an apt label, because of his behavioral curiosity about finance. However, in most cases, the line separating a value investor from a contrarian investor is blurred. Drayman’s contrarian investment strategies are derived from three measures: price to earnings, price to cash flow, and price to book value. These measures are closely related to value investing, and in particular to so-called Graham and Dodd investing (a form of value investing named after Benjamin Graham and David Dodd, co-authors of “Security Analysis”).

conclusion

Finally, value investing can only be defined as paying less for a stock than its estimated value, where the method used to calculate the stock’s value is truly independent of the stock market.. Where intrinsic value is calculated using an analysis of discounted future cash flows or asset values, the resulting intrinsic value estimate is independent of the stock market. But, a strategy based on buying stocks that trade at lower price-to-earnings, price-to-book and price-to-cash flow multiples than other stocks is not value investing. Of course, these strategies have been quite effective in the past and will continue to work well in the future.

The magic formula created by Joel Greenblatt is an example of one such effective technique that often results in portfolios created by true value investors. However, Joel Greenblatt’s magic formula does not attempt to calculate the value of the stock purchased. So, while the magic formula may be effective, it is not a true value investment. Joel Greenblatt is himself a value investor, because he calculates the intrinsic value of the stocks he buys. Greenblatt wrote The Little Book That Beats the Market for an audience of investors who have neither the ability nor the inclination to value businesses.

You cannot be a value investor unless you are willing to calculate business values. To be a value investor, you don’t need to value the business exactly – but you do need to value the business.

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