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The Ultimate Guide to Value Investing

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value investingValue investing is a trading strategy where investors purchase stocks that are intrinsically more valuable than their current share price. Using this strategy, value investors measure the internal value of a business compared to its current market price.

The History of Value Investing

The fathers of value investing are Benjamin Graham and David Dodd who introduced the approach to investors in their 1934 book, Securities Analysis. Since its release, Securities Analysis has been widely accepted, and is the trading strategy Warren Buffett used to make his fortune. Over the years the strategies in the books have been updated to reflect new information. The book has been updated six times with the most recent edition released in 2008.

Warren Buffett’s Addition To Value Investing

After being mentored by Graham, Warren Buffett added executive management analysis to the strategy. Buffett believed that a company’s health and stability directly correspond with the skill and expertise of its executive team. In this regard, Buffett invests more in people than he does businesses. He relies heavily on valuing a business intrinsically, however, before making his final decision he assess the ability of the managers to run the company’s day to day operations. Warren Buffett has become the most successful investor of all-time using this two-fold strategy.

Value Investing

The best investors take their time before making a purchase or sale, and are in it for the long haul. A true value investor is looking to purchase a stock they plan on owning for at least 5 years. It takes a ton of work (and even more research) to calculate the intrinsic value of a company.

value investing moneybags

Fundamental Measures of Value

For new investors there are several fundamentals you can use to determine the intrinsic value of a company. These include:
• Price to Book
• P/E vs. Industry P/E
• Debt To Equity Ratio
• Current Assets to Current Liabilities
• Earnings Growth
• PEG Ratio

Note: All of the following fundamentals can be easily found on Yahoo Finance.

fundamental financial ratiosPrice to book
Generally, a lower price to book ratio indicates an undervalued company. To calculate the P/B ratio simply take the most current stock price and divide it by total assets minus intangible assets and + liabilities.
Stock Price/(Total Assets – (Intangible Assets + Liabilities))

P/E vs. Industry P/E
The price to earnings ratio (P/E) is the company’s current share price divided by its latest earnings per share figures.

Simply compare the company you are looking at to its competitors P/E ratios to see if your company has a lower share price to its earnings than its competitors do. This is an indicator of a value investment.

Debt To Equity Ratio
The company’s debt divided by its equity. For value investing this ratio should be well below 1.

current ratioCurrent Assets To Current Liabilities
This ratio measures the companies ability to meet its current obligations. Just like in personal finance a company must be able to pay its current “bills”. If a company cannot meet its current obligations then it is not a value investment.

Earnings Growth
Calculate using the compound growth in the company’s earnings over the past 5 years. A value investor typically looks for a company with at least a 7% compound growth in earnings over the past 5 years.

PEG ratio
Price/Earnings to Growth Ratio is a trade off between a company’s price to its earnings and calculated growth. In general companies with a high PEG ratio tend to be overvalued and not a suitable investment for a value investor.

Advanced Measures for Value Investing

The following two sections are for intermediate to advanced investors who already have a basic understanding of finance and mathematics.

Asset Value Approach

The asset value approach focuses on a company’s net asset value, which is the fair market value of its assets minus its liabilities. The approach is most commonly used for valuing holding companies invested in securities, real estate, or other items of significant worth.

NAV = Total Assets – Total Liabilities

Real Estate Holding Company

Valuing a real estate holdings can be extremely tricky for an individual investor. Without having an appraisor value the property the only way to somewhat accurately analyze the value of a companies real estate holdings is to look at similar properties (age, size, location, improvements, grade/slope, and environmental risks) that have recently sold.

Most of the time (for commercial properties) it is very difficult (if not impossible) to locate a similar property that has sold recently. Short of hiring an appraiser to assess the property you can check a company’s financial statements to look for fair value of its properties.

Securities Holding Company

Valuing securities is a little more feasible than trying to value real estate as an individual investor. To determine the fair value of a company’s security holdings all one has to do is check the current market price for any stocks, bonds, mutual funds, certificates of deposit, options and other securities the company may be holding. Analyze each security the company owns and subtract the company’s total liabilities.

Discounted Cash Flow Approach

time value of moneyThe discounted cash flow (DCF) approach is used for business earning income. In this approach you will discount future cash flows back to present value. This approach uses the time value of money concept where a dollar is worth more today than in a year from now.

dcf value investing

• CF = cash flow
• r = discount rate
• n = time

Note: In the following sections I will cover how to predict cash flows and select a discount rate for the equation above

Cash Flow Forecasting

There are a few variables in this equation that we have to calculate. Predicting future cash flows is an art in itself. Here is a guide to get you started on cash flow forecasting.

forecasting cash flowsA simple way to predict cash flows (although unreliable) is to take the company’s cash flows for the previous 5 years and determine what the compound growth rate is. Then apply this to rate to future cash flows to predict how much cash the company will generate over the next five periods (or however long you choose to predicting into the future). This method is very unreliable, however, because past performance does not guarantee future success. There are also many variables that effect cash flows and the more complicated the business model the harder it will be for an individual investor to calculate and predict future cash flows.

When I worked as a valuation analyst for private businesses I used to break down the company’s income statement and look at each item very carefully. By understanding how a company makes money, what they are investing their cash in and what expenses they will incur you can more accurately predict a company’s cash flows then the method mentioned above. After analyzing the income statement and predicting net income you can then move to their statement of cash flows. Here you will be adjusting items that effect their cash flows. Try and see if the company has any plans to raise more capital (debt or equity financing), if they will be investing in new operating equipment or buildings and production facilities or if they have a large amount of inventory write offs coming up. The more information you can gather the more accurate your final cash flow projections will be. This step takes an extreme amount of time and research, but a value investor fully understands the company before they make an investment decision.

There are many additional resources and tutorials to help you predict future cash flows, simply look for an example that is related to the company your analyzing and study what professionals use to value and estimate that particular type of business.

Choosing a Discount Rate

The most common way for investors to choose a discount rate is to apply the concepts of weighted cost of capital (WACC). You must be extremely precise in this calculation, because just an extra percentage point or two will really alter your entire valuation.

There are 3 components to calculating WACC:
• Cost of Equity
• Cost of Debt
• Capital Structure

Cost of Equity
The most common way to calculate the cost of equity is to use the capital asset pricing model.
(Re) = Rf + Beta (Rm – Rf)

• Rf = Risk Free Rate*
• Rm = Risk Premium**
• Beta measures how much a company’s share price moves in comparison to the entire market. A company with a Beta of 1 moves in line with the market. A company with a Beta greater than 1 has exaggerate movements, and less than 1 means the company moves opposite of the market (such as the price of gold). You can look at a company’s key statistics on Yahoo Finance to see what the Beta is.

*The risk free rate is the current interest rate on a long-term treasury bond
**A risk premium is a percentage added to the risk free rate to adjust for the risk of investing in a stock over a risk free bond. Barra and Ibbotson offer equity market risk premiums for public companies.

Cost of Debt
Rd (1-corporate tax rate)
• Rd = current market price the company is paying on its debt
Simply multiply the current interest payments by the tax savings the company incurs for the interest it pays on its debts.

Capital Structure
WACC = Re x E/V + Rd x (1 – corporate tax rate) x D/V
• E/V = a ratio comparing the company’s equity to total value
• D/V = a ratio comparing the company’s debt to total value
• Re = Capital Asset Pricing Model (from above)
• Rd = Current Market Price on Debt (from above)
• Total Value – Debt + Equity

To calculate simply multiply the company’s cost of equity by the percentage of equity to total value and add that to the cost of debt multiplied by the percentage of debt to total value.

Once you have the companies WACC you can use that to create a discount rate for the future cash flows you predicted above.

Still with me?

Executive Management Analysis

managementThis strategy was famously added to the value investing approach by Warren Buffett. He deduced that a company’s ability to generate profit was directly correlated to the skill and expertise of its executive management. By making sure the management team is qualified and skilled enough to run the operation he minimizes his risk.

This is very important because there is a lot of criticism to the basic value investing approach. For instance a company may have some new financial turmoils that have not yet been reflected in the income statement and balance sheet. This could lead value investors to finding a high intrinsic value, however, the market has already adjusted for the new information. It is important to understand a company’s management team – their history and their ability to run operations. This will help aid in the decision to make smart investment choices.

For a value investor the company must have solid finances that indicate more value than the market is currently reflecting. Taking this a step further and looking at the management team will help you make a more informed decision when investing. The more information you can arm yourself with the better decisions you will be able to make.

How To Begin Value Investing

There is way too much to cover in one post to become a master at value investing. Ultimately value investing comes down to your ability to get a clear picture of a company’s true value and compare it to its current market price. When doing initial valuation fundamentals will help you identify great value investing opportunities and business you should spend more time researching to see if they fit your investment needs.

By now you should have a basic understanding on what a value investor is and how to locate potential stocks for investment. There is a lot to learn to master value investing and new investors should carefully read and study all the strategies before making investment decisions. My favorite books on the subject are the 6th edition of Securities Analysis by Benjamin Graham and David Dodd and The Intelligent Investor by Benjamin Graham. Both of these books cover (in great detail and with many examples) ways to identify value stocks and how to measure the intrinsic value of a company. For beginners I highly recommend reading these books carefully before making any value investments.

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