Warren Buffett is arguably the most successful investor of all time. With 83 years of investing experience, he has a proven track record of beating the stock market, averaging a 20% annual return versus the market’s 10%. During this time, he has amassed a net worth of $145 billion.
Alongside his business partner of over 60 years, the late Charlie Munger, they have grown Berkshire Hathaway to just over $993 billion.
So, how did they create all this wealth for themselves and the shareholders of Berkshire Hathaway?
Value Investing Explained
Value investing is an investment strategy that involves buying shares of companies that trade at a discount to intrinsic value (below what they are worth). It is the strategy that the great investors – Warren Buffett and the late Charlie Munger and Benjamin Graham – use(d) in their portfolios.
Value investors look for key traits in the companies they invest in. These companies often:
- Have increasing profitability and growing free cash flow
- Have simple business models and strong fundamentals
- Consistently churn out returns for shareholders
- Trade below intrinsic value
Value investors also invest with a margin of safety, a principle where investors only buy shares when the stock’s current price is adequately below their estimate of intrinsic value.
Calculating a company’s intrinsic value is complicated and prone to errors since assumptions about the future must be made. Therefore, a margin of safety guards against investment losses if future assumptions are wrong or change before an investor can reflect said changes. A margin of safety can also boost returns if future assumptions are close to accurate.
What Does Value Investing Entail
Because of the main principle of value investing (i.e. buying shares when they trade below intrinsic value), value investors are often contrarian actors – they think and behave differently.
Some of these contrarian behaviours include the following.
Not Following The Herd
Value investors don’t follow trends because trends drive up stock prices without considering a company’s fundamentals. This results in chasing overpriced stocks, which goes against the principle of value investing. Instead, value investors are cautious when stocks are pushed to unsustainable levels and prepare for a reversal in market sentiment.
“Be fearful when others are greedy and be greedy when others are fearful.”
Warren Buffett
Patience
Since value investors only buy shares when they trade below intrinsic value, patience plays a huge role in successful value investing. A company can be on a value investor’s watchlist for months, even years, before buying shares.
Similarly, patience is required after investing. Because value investors buy shares at a discount to intrinsic value, it takes time for the stock to bounce back and generate investor returns.
“The big money is not in the buying or selling, but in the waiting.”
Charlie Munger
Analysing Company Reports & Financial Statements
To find a company’s intrinsic value, investors must analyse a company’s financial statements and corporate filings. Doing such research highlights some key insights that can be used when estimating a company’s growth potential.
“You must thoroughly analyse a company, and the soundness of its underlying businesses, before you buy its stock; you must deliberately protect yourself against serious losses.”
Benjamin Graham
Value Investing Ratios
When looking at potential investments, value investors look at the following ratios to get a general idea about a company’s relative valuation and risk.
*This is not an exhaustive list.
Price-to-Earnings Ratio
The price-to-earnings (P/E) ratio compares a stock’s current price to the company’s earnings. It tells investors what the market would pay for £1 of a company’s profits based on its current stock price.
For example, if a company has a P/E ratio of 20, the market would be willing to pay £20 for £1 of its profits.
A high P/E ratio may suggest that a company is overvalued/expensive relative to the profits it generates. A low P/E may mean a company is undervalued/cheap. But there are some nuances to this.
A high P/E ratio may suggest that a company is a market leader with a quality business model, therefore demanding a higher P/E. Because a company is a dominant force in its industry and likely to be in the future, investors are comfortable paying more for a piece of its annual profits.
On the other hand, a low P/E may also suggest that a company is stagnating or in decline. These companies appear ‘cheap’ when looking at metrics alone but have issues keeping up with their competitors and the broader market. Because of their apparent ‘cheapness’, investors are lured into thinking they’ve found a good stock when they haven’t. Companies like this are called value traps – they seem cheap but are struggling and deserve the low P/E.
These nuances also apply to other valuation metrics.
Price-to-Book Ratio
The price-to-book (P/B) ratio compares a company’s market cap to its book value. Book value, commonly called equity, is calculated by deducting total liabilities from total assets. The P/B ratio tells an investor what the market would pay for £1 of a company’s book value.
A price-to-book value of 1 means that the company trades equal to its book value, and a price-to-book value greater than 1 indicates that a company trades at a premium to (higher than) book value. A P/B ratio of 10 implies that the market would be willing to pay £10 for £1 of a company’s equity.
On the other hand, a price-to-book value less than 1 indicates that a company trades at a discount to book value. A 0.5 P/B ratio means a company trades at half its book value.
Debt-to-Equity Ratio
The debt-to-equity (D/E) ratio tells investors the proportion of debt relative to equity a company uses to finance its operations. A low debt-to-equity ratio (a D/E ratio below 1) shows that a company uses more equity than debt, and a high debt-to-equity (a D/E ratio above 1) means that a company uses more debt than equity.
A high debt-to-equity can be an issue for value investors since too much debt is considered a risk.
How Do Investors Find A Company’s Intrinsic Value?
Value investors often use financial models to calculate a company’s intrinsic value. Methods like metric and peer analysis don’t calculate intrinsic value but give investors an idea of a company’s relative value – if it’s overvalued or undervalued.
Financial Models
Financial models use historical company finances and investor assumptions of the future to estimate intrinsic value. The most common financial model is the Discounted Cash Flow (DCF) model.
The discounted cash flow model uses an investor’s future assumptions to project a company’s free cash flow into the future. These future cash flows are then discounted* (brought back to today’s money value) and totalled to calculate a company’s intrinsic value.
If the intrinsic value (total value of all discounted future cash flows) exceeds the company’s current value, the company is considered undervalued.
*Future cash flows are discounted because of the time value of money – £1,000 today is worth more than £1,000 in five years.
Metric Analysis
Metric analysis refers to analysing a company’s historical financial metrics to determine if it trades above or below its long-term average. For example, if a company’s historical price-to-earnings ratio is 25 and its current P/E ratio is 15, it may be considered undervalued.
Since the price-to-earnings (P/E) ratio tells what the market would pay for £1 of a company’s earnings, a lower-than-usual P/E ratio may suggest that a stock is undervalued. Remember the nuances, though.
Peer Analysis
Peer analysis compares a company’s financial metrics against that of the company’s competitors (or peers). It gives investors insight into the relative value of a company – whether it’s undervalued or overvalued.
For example, if three similar companies have P/E ratios of 18, 19, and 20, and a fourth company has a P/E of 10, the fourth company may be deemed undervalued relative to the others.
For a company to be undervalued using peer analysis, there should be a stark difference in the metrics being compared. If the fourth company in the above example had a P/E of 16, there isn’t enough evidence to say it is undervalued, even though it is lower.
Section Summary
Performing a discounted cash flow analysis is essential to value investing because investing metrics don’t always paint the entire picture.
A P/E lower than a company’s historical P/E may be the new normal for that company and not necessarily mean it’s undervalued. Similarly, a significantly lower P/E ratio compared to a company’s peers can suggest that the company is fairly valued and the peers are overvalued.
Investors only use metric and peer analyses to supplement a detailed, well-built financial model.
Value Investing Risks
While value investing can be rewarding, it comes with several risks. Some of these include the following.
Buying Overvalued Companies
Buying shares in overvalued companies is an easy way to lose money fast.
Value investors often use conservative growth estimates in their models, sometimes resulting in an intrinsic value lower than the company’s current value. Ignoring those estimates and proceeding to buy the company’s stock can lead to considerable investment losses.
Similarly, investors can overestimate a company’s intrinsic value. Optimistic growth assumptions can be used in the model, resulting in a high intrinsic value estimate. Even with a reasonable margin of safety, investors may still lose money.
Minimal Diversification
Because value investors analyse annual reports and financial statements for every company they own, their portfolio is often concentrated in a couple of stocks. Take Warren Buffett and Berkshire Hathaway’s investment portfolio as an example. Six companies account for just over 75% of the entire portfolio.
Focusing your investment portfolio on a few companies you understand deeply can lead to significant gains, but the impact of one bad investment is amplified.
Listening To Your Emotions
Ignoring a company’s fundamentals and making investment decisions based solely on emotions is a risky game.
Behind every stock is a company – when a company is doing well, the stock price usually follows suit. When a company is doing poorly, expect the stock price to do the same.
Making investment decisions based on emotions leads to avoidable losses. Seeing a stock skyrocket can make you feel you’re missing out, but buying a stock because it is going up is no reason to buy it at all.
Similarly, falling share prices may make you want to sell your shares. But if the company’s fundamentals still make sense, these falling share prices may present an opportunity to accumulate cheaper shares.
Base your investing decisions on the facts. Not your emotions.
Is Value Investing For Me?
Value investing requires hours of research and analysis before purchasing a stock and keeping up to date with the happenings of the companies you own. Sometimes, value investors may research a stock and wait months before owning it. Sometimes, they may do hours of detailed research and never own the company.
If you are patient, in control of your emotions, and can wait for your preferred companies to fall adequately below intrinsic value (and bounce back), you may have what it takes to be a value investor.
Summary
Value investing is a strategy where investors buy shares of companies when they trade at a discount to intrinsic value, and value investors spend loads of time analysing annual reports and financial statements to learn more about the company. They are also patient since it can take time for a company to fall below their estimate of intrinsic value and bounce back and begin generating returns.
Like all investing strategies, there are risks associated with value investing. Because value investors analyse company reports and financial statements for each company they own, their investment portfolios are often concentrated in a handful of stocks. If one company performs poorly, it can hamper the entire portfolio.
It’s also vital to be mindful of buying overpriced stocks and basing investment decisions on emotions instead of facts. These risks can seriously hinder investment success and must be avoided at all costs.
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