Investment has been around for a long time as a means to grow wealth. Furthermore, with the passage of time and the advancement of mathematics, the investors were able to find new investment strategies based on facts and data. Value Investing is one such equity investment strategy that has been most popular since the early 20th Century. First popularized by Benjamin Graham in the 1920s and 1930s, Value Investing has thus seen some great legendary investors in Warren Buffet, Charles Munger, and Rakesh Jhunjhunwala to name a few. Using Value Investing and adding their own tweaks, these investors have made Billions of Dollars. In this article, we will take a dive inside Value Investing as a concept and understand its nuances. Let's begin!
What is Value Investing?
Going by definition, Value Investing is thus purchasing something at a price less than its intrinsic value. In this definition, we have three important terms: Price; Intrinsic; and Value.
1. Firstly, price is an amount of money paid for something like an asset.
2. Secondly, Value is what you get for paying the price.
3. Finally, the term intrinsic refers to the unique properties or features of the asset that
generate the value.
Example: You are walking through a salvage yard and see an old car is on sale at INR 10,000. You thus look around the car and check its health. However, after thoroughly inspecting each aspect you think the spare parts like engine, tires, and gearbox should alone cost INR 12000 and if the body of the car is sold separately it would earn you around 4000.
Now, let us check out the arithmetic for the deal:
1. Price for the car: INR 10000
2. Estimated value of spare parts: INR 12000
3. The estimated value of body: INR 4000
4. Estimated Intrinsic Value of the car today: 12000+4000 = INR 16000
The above example simply shows you believe that a car’s fair price should be INR 16,000.
Hence, this difference between your estimation and market price gives an opportunity for Value Investing or put simply the asset is available for ‘Sale’. Hence, Value Investing is a process involving a high degree of due diligence and inspection to arrive at the fair price of the asset and then deciding if the asset will fetch your financial benefit in the future due to current mispricing.
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How does Value Investing work?
Value investors generally thus look for companies with solid fundamentals and prospects whose share price does not reflect their true value. Also, such companies are called to be undervalued and it has been seen that these companies do receive their fair share price sometimes; it can be sooner or later. We also have understood the definition of Value Investing. But, how does an investor make money using Value Investing?
The question can be answered in 5 points.
1. Identifying the mispriced asset like the share of a listed company.
2. Outline the reasons that thus support and refute the claim for mispricing.
3. Also, weigh the reasoning and assign the pair market price to the asset.
4. Wait for the asset price to rise to reflect its true value.
5. Sell the asset and book profit.
Each of these 5 steps can be thus elaborated into a separate book as each step has many different ways of being implemented. Moreover, the reason for the same is that the methods vary depending on the asset class or even different stocks from the same industry. Furthermore, let us understand working with an example. There is a telecom company ABC ltd. which is doing great. It has thus reported a good profit in the present quarter and for the last 3 years, its growth rate has been higher than the industry growth rate.
Also, its current share price is INR 500/share. However, suddenly, news comes that there has been a lot of fake news being posted concerning Covid19 and thus causing nation wise panic. Thus, taking an extreme step, the Indian Government shuts the internet connection for a week to contain the rumors. Subsequently, investors of ABC Ltd. see this as a red flag and start selling their shares through brokers resulting in a price drop of 20%.
But you being a Value Investor consequently see this reaction to be based on emotion and feel that INR 400 is much less than the true price of an ABC Ltd. share as the fundamentals like revenue and profit of the company is still strong and shutting the internet connection for few days does not affect the fundamentals and intrinsic value in any way. Hence you buy the shares at INR 400/share. 2 Weeks later price starts to rise and reaches its fair value of INR 500. You thus earn INR 100/share.
How to calculate intrinsic value?
Moreover, there are a lot of ways to calculate intrinsic value. But quantitatively the most frequent method is called Discounted Cash Flow Model. Also, the formula looks like the following:
NAV = CF0/(1+r0) + CF1/(1+r1)^2 + CF2/(1+r2)^3 + CF3/(1+r3)^4 …… +CF10/(1+r10)^11
NAV = Net Asset Value or Intrinsic value of the company
CF= Cash Flow to Firm; 0,1,2..10 are periods with 0 representing current year
r = Discount rate
G = Terminal Growth rate
t = Period after which growth is constant i.e Terminal period.
Cash Flow to the firm is released by the company in the annual report.
Let us thus understand this model by example. For simplicity, we will take only three years’ cash flow and growth rate in cash flow equal to 10% till year 3 and 5% on perpetuity. Now we will thus plug in the following numbers.
CF0 INR 100
CF1 @10% INR 110
CF2 @10% INR 121
CF3 @10% INR 132
CFt @5% INR 139
Now we plug in the values in the DCF formula
= CF0/(1+r0) + CF1/(1+r1)^2 + CF2/(1+r2)^3 + CF3/(1+r3)^4 + CF10(1+G)/(rt-G)
=[100/(1+.12)]+[110/(1+.12)^2]+ [121/(1+.12)^3]+[132/(1+.12)^4]+ 139/(.12-.5)
=89.28 + 87.69 + 86.12 + 83.88+198.57
NAV =INR 545.54
Price per share = 545.54/100 = INR 5.45/share (outstanding share =100)
Fundamentals of stock selection
Also, there are various factors that decide movement in the share price of a company. Moreover, these factors can be the performance of the company, microeconomic factors, macroeconomic factors, behavioral aspects of investors, etc. Subsequently, to have an accurate understanding of the company one should look at three
documents published by the company:
1. Balance Sheet: Details of assets and Liabilities.
2. Profit and Loss Statement: Details of revenue and expenses.
3. Cash Flow Statement: Cash Inflow and Outflow.
These three documents thus give the investor an idea of the company’s present status. Also, a smart value investor needs to forecast a company’s future standing. This requires assessing economics at the industry, national, and global levels. It also requires looking at competition, customers, and public sentiments.
Important ratios to be considered
Furthermore, some of the ratios reflect the financial health of the company and it is easy to understand. There are as mentioned below:
♠ Price to Earnings Ratio: Simply put, it refers to the amount an investor has to pay INR 1 from the company. So, if the PE ratio is 25 it means the investor is paying INR 25 to earn INR 1. Also, Higher PE shares are looked at as expensive but it also reflects investors have trust in the companies’ future potential.
♠ Price to Book Ratio: Book value reflects the value of assets of a company. PB ratio just shows the ratio of share price and declared the asset value of the company.
♠ Return on Equity: ROE is an extremely important ratio as it tells the earnings available to shareholders after all the expenses including interest.
♠ Debt to Equity Ratio: DE ratio reflects the corporations’ funding structure. If it is 1 then it means company debt and equity value are the same.
♠ Price Earning to Growth Ratio: Moreover, the PEG ratio is an extension of the PE ratio as it includes growth. Also, the PE ratio divided by growth in earnings gives us the PEG ratio. Investors use it as one of the metrics to see if stock is overvalued or undervalued.
Advantages of Value Investing
1. Fact-based approach: Firstly, value Investing is based on facts and numbers; hence the approach is superior based on other trend-based approaches.
2. Solid track record: Secondly, value Investing has been taken up thus by some of the greatest investors in the world.
3. Does not get affected by price momentum: Thirdly, the strategy is rigid as it does not vary with temporary variation in the market.
4. Long term strategy: Finally, unlike short term strategies value Investing does not
require constant tracking of effects arising from human tendencies.
Disadvantages of Value Investing
1. Usually not used for the short term: Firstly, Value investors thus have their money tied up for a longer period; earning profit via market sentiment is not done using Value inventing.
2. High-Grade research and due diligence required: Lastly, since Value Investing is based on facts and numbers, the methodology can be tedious.
It should thus be noted that although Value Investing is factual, it does not give 100% the accurate value of a share as companies derive their value from abstracts qualities as well, which cannot be quantified. However, at the same time, the strategy of Value has been proven to reap a great reward if done right. We also have over 100 years of data and dozens of Billionaire investors to back this concept. Ready to have an exciting future? Happy investing!
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