What is value investing? How it works?
Value investing seeks to buy assets at prices below their intrinsic value, focusing on long-term gains by evaluating a company's fundamentals and financial health.
Understanding value investing
Value investing is a strategy where investors seek to purchase assets, such as stocks, bonds, or real estate, for less than their true worth. The goal is to identify the intrinsic value of these assets and wait for opportunities to buy them at prices below that value.
The roots of value investing trace back to the work of Benjamin Graham and David Dodd in the 1920s, during their time at Columbia Business School. Their ideas are detailed in the classic books *Security Analysis* and The Intelligent Investor. Warren Buffett, Graham's most famous disciple, has become the most well-known advocate of value investing.
At its core, value investing views stock ownership as holding a stake in a business, and thus requires evaluating a company's financial health through fundamental analysis to estimate its intrinsic value. Intrinsic value isn't a precise figure but a range, given the complexity of such assessments. As Warren Buffett wisely puts it, "It is better to be approximately right than precisely wrong." Investors aim to buy stocks trading at or below this estimated value.
How to determine intrinsic value
To calculate a company's intrinsic value, the main approach involves estimating the present value of its future cash flows. This requires making projections about future cash flows and determining an appropriate discount rate to bring those future earnings back to their present value. Given the uncertainty and assumptions involved, intrinsic value often comes out as a range rather than a fixed figure. As Warren Buffett emphasized, intrinsic value is the “only logical approach” to assess the true worth of investments.
Buffett defined intrinsic value as the discounted value of the cash that can be extracted from a business over its remaining lifespan. Several financial metrics help to determine whether a stock is trading below its intrinsic value, though none of them should be used in isolation. They serve as useful tools to begin deeper analysis.
Using the Price-to-Book (P/B) ratio to estimate intrinsic value
The Price-to-Book (P/B) ratio compares a company's stock price to its book value per share, which is the company's net worth (total assets minus liabilities) divided by the number of shares outstanding. In some cases, intangible assets like goodwill are excluded from this calculation to get a clearer picture of the company’s tangible book value.
A P/B ratio below 1.0 theoretically suggests that a company’s stock is undervalued, as it is selling for less than the company’s net worth. For example, some financial institutions may trade below their book value, while rapidly growing companies may have stock prices far above their net worth. However, the significance of the P/B ratio can fluctuate depending on market conditions and business cycles. When stock prices rise, the P/B ratio increases, and it decreases when stock prices fall.
Using the Price-to-Earnings (P/E) ratio to estimate intrinsic value
The Price-to-Earnings (P/E) ratio compares a company’s stock price to its annual earnings. For example, if a company has a P/E ratio of 15, it means that investors are willing to pay 15 times the current earnings for a share of the company.
Generally, a lower P/E ratio suggests that a stock might be a value investment, although there is no fixed threshold that categorizes a stock as undervalued. The P/E ratio should be compared against the market average to assess relative value. Just like with the P/B ratio, a low P/E ratio alone does not guarantee a good investment. It’s a starting point for deeper research into the company’s financials and future prospects.
Value investing through mutual funds
Mutual funds can provide a convenient way to engage in value investing. Major fund providers offer both actively managed and passively managed value funds. For instance, the Vanguard Value Index Fund Admiral Shares (VVIAX) focuses on value stocks. Comparing it to the Vanguard Growth Index Fund Admiral Shares (VIGAX) highlights the differences between these investment styles.
The value fund has an average P/E ratio of 18.1, while the growth fund has a much higher average P/E ratio of 38.8. Similarly, the P/B ratio for the value fund is 2.1 compared to 8.2 for the growth fund.
Recent performance trends show that growth funds have outpaced value funds, as evidenced by their 10-year returns. The value fund has delivered an average return of 10.91%, whereas the growth fund has achieved a 16.79% return.
However, this does not necessarily mean that growth investing is superior to value investing. Both approaches have their periods of outperformance. For those interested in a mix of both styles, an S&P 500 index fund offers a balanced approach that incorporates elements of value and growth investing.
Alternatives to value investing
Value investing is just one of several strategies for selecting stocks. A key alternative is growth investing, which focuses on companies that are expanding at a much faster rate than others. While value investors seek stocks that are undervalued based on metrics like low P/E or P/B ratios, growth investors prioritize companies with rapidly increasing revenues and profits, even if these stocks have very high P/E or P/B ratios.
Both value and growth investing have the potential to outperform the broader market over time. In recent years, growth investing has outpaced value investing, with companies like Amazon, Apple, and Tesla delivering impressive returns. However, there have been periods in the past when value investing has produced better results.
In addition to value and growth investing, other strategies bypass fundamental analysis entirely. For example, technical analysis relies on historical market data to forecast future price movements, while day traders focus on short-term market fluctuations, disregarding a stock’s intrinsic value.
