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Understanding Value Investing

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Shouldn’t we all be value investors? After all, who wants to buy crummy stocks? However, in this case, value investing refers to a particular philosophy that drives the way an investor approaches selecting stocks.

I should say up front that value investing is not junk investing. Value investing is not shopping the bargain bin for seconds and discontinued models. It is not about buying anything less than $3 per share.

Value investing is about finding stocks that the market has not correctly priced. In other words, a stock that is worth more than is reflected in the current price.

Value Investor

The value investor, perhaps more than any other type of investor, is more concerned with the business and its fundamentals than other influences on the stock’s price.

Fundamentals, such as earnings growth, dividends, cash flow, and book value are more important than market factors on the stock’s price. Value investors are also buy and hold investors who are with a company for the long term.

If the fundamentals are sound, but the stock’s price is below its obvious value, the value investor knows this is a likely investment candidate. The market has incorrectly valued the stock. When the market corrects that mistake, the stock’s price should experience a nice rise.

Stock XYZ is down 25% from its high of six months ago. Is it a candidate for a value investor? Maybe, but probably not. Value investors aren’t usually interested in beaten up stocks unless there is no fundamental reason for the drop in price.

The Market’s Right

This happens; however most of the time the market is right and a stock gets hammered because of any number of sound fundamental reasons (declining earnings, declining revenues, are good examples) or something fundamental changes in their market or product line. A pharmaceutical company has a top seller yanked off the market by the government - that fundamentally changes the company.

On the other hand, other pharmaceutical companies may see their stock clipped also even though they are not part of the recall. That may make them worth a look by a value investor.

Value Investing Guidlines

What do value investors look for in a potential investment? Here are some guidelines gathered from a variety of value investors. Investors should settle on a formula that works for them, but it will probably include as a minimum these elements:
  • A Price Earnings Ratio (P/E) in the bottom 10 percent of its sector.
  • A PEG of less than one. (The link will take you to an article that explains how to calculate PEG.) A PEG of less than one may indicate the stock is undervalued.
  • A Debt to Equity Ratio of less than one.
  • Strong earnings growth over an extended period. A realistic number might be in the 6% - 8% range over 7 to 10 years.
  • A Price to Book ratio of one or less.
  • Don’t pay more that 60% to 70% of the stock’s intrinsic per share price (see below for more on intrinsic price).

A big challenge for the value investor, and all investors for that matter, is reconciling market value and book value.

Intrinsic Value

Current accounting standards are adequate for measuring buildings and equipment (book value), but as our economy has moved to a more technology/knowledge-base, many of these intellectual assets never show up on financial statements.

Value investors acknowledge that their target investment company is much more valuable as an ongoing business (expected cash flows, etc.) than its assets (market value). In many cases, it is the intangibles – patents, trademarks, research and development, brand, and so on – that drives the expectations of future growth, not hard assets.

How do you calculate the value of intangible assets? An article from Investopedia.com offers a step-by-step process to come up with a number.

Coming up with the intrinsic value of a stock is a complicated process and there are a number of ways to get to the number.

Finding Intrinsic Value

Fortunately, there are several places you can go on the Web to find the number. MorningStar.com calculates the number, which it calls “fair value,” on its site, however you need to be a member. Take the two-week free trial to see if you like their service. Another good source is Reuters, which also requires a registration, but it is free.

However you arrive at the intrinsic or fair value, give yourself a margin of error with the thought that if the calculation is wrong you might over pay. If you use one of the services mentioned above or another source to find the intrinsic value, determine if they have already factored in a margin of error.

For example, if you believe the intrinsic value is $40 per share, give yourself a margin of safety and lower the target to $36 per share.

Conclusion

Many people have made fortunes using a value-based approach to investing. This overview suggests a philosophy that works over time if you buy carefully and hold for the long term.

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