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Value investing is a strategy where investors aim to buy stocks, bonds, real estate, or other assets for less than they are worth. Investors who pursue value investing learn to uncover the intrinsic value of assets, and develop the patience to wait until they can be purchased at prices that are lower than this intrinsic value.
In this article, we’ll look in detail at value investing, including its history, how to measure intrinsic value and alternatives to value investing.
What Is Value Investing?
Value investing is nothing more or less than buying investments on sale.
The origins of value investing go back to research by Benjamin Graham and David Dodd in the 1920s, when both men began teaching at Columbia Business School. Many of the concepts of value investing are described in their book, “Security Analysis,” and in Graham’s book, “The Intelligent Investor.” Warren Buffett, the most successful practitioner of value investing, was a student of Graham’s at Columbia.
Value investing starts from the premise that an investor who buys stockin a company owns part of the business. While this may seem obvious, many investors “play the market” without regard to the underlying fundamentals of the companies they own.
As a business owner, the investor should evaluate the financial statements of companies to assess their intrinsic values. This type of evaluation is known as fundamental analysis.
Intrinsic value is rarely a single number. Rather, due to the many assumptions that go into valuing a complex enterprise, intrinsic value is often a range. This lack of precision shouldn’t concern an investor.
In the words of Mr. Buffett, “It is better to be approximately right than precisely wrong.” Value investors will consider investing in a company whose price is at or below its intrinsic value.
How to Calculate Intrinsic Value
Fundamentally, calculating a company’s intrinsic value involves determining the present value of a company’s future cash flows. This in turn requires estimating future cash flows, and the interest rate to use to determine the present value of those cash flows. Given these assumptions, it’s easy to understand why intrinsic value is often a range rather than a precise number.
Buffett called intrinsic value the “only logical approach” to evaluating the relative attractiveness of investments and businesses.
“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life,” he wrote.
There are a number of metrics that some use to determine whether a company is selling below its intrinsic value. While none of these should be relied upon blindly, they can be a helpful starting point.
Determine Intrinsic Value with the Price-to-Book Ratio
Price to Book, or the P/B ratio, compares the stock price of a company to its book value per share. Book value per share is the company’s net worth (assets minus liabilities) divided by the number of outsanding shares. In some cases, investors will exclude certain intangible assets (e.g., goodwill) from the calculation of the PB ratio.
In theory, any value below 1.0 indicates that a company’s stock is selling for less than the net worth of the company. Today, some banks trade below their book value, while some growth companies trade at many multiples of their net worth.
There is, however, no one P/B ratio that defines value versus growth investments, as these numbers change throughout business cycles. As stock prices go up, the P/B Ratio goes up, and as prices go down, so does the ratio.
Determine Intrinsic Value with the Price-to-Earnings Ratio
Price to earnings, or the P/E ratio,compares a company’s stock price to its annual earnings. A P/E ratio of 15, for example, indicates that it will take 15 years at the company’s current earnings to equal the cost of the share.
The lower the P/E ratio, the more likely the company is considered a value stock. While there is no fixed level that automatically qualifies a stock as a value investment, the PE ratio should be lower than the average P/E ratio of the market as a whole.
As with the P/B ratio, keep in mind that a lower P/E ratio doesn’t mean a company is a good investment. These metrics are a starting point for further analysis.
Alternatives to Value Investing
Value investing is not the only approach to stock selection. Perhaps the most important alternative is growth investing. Where value investing looks for companies with stocks that are on sale, growth investing looks for companies that are growing much faster than most other companies.
Where a value investor may look for a low P/E ratio or P/B ratio, a growth investor is more concerned with how quickly a company is growing its revenue and profits. In fact, many growth companies have astronomically high P/E and P/B ratios.
Over time, both approaches can outperform average market returns. In the current market, growth investing has outperformed value investing for a number of years. This can be seen most clearly in the returns of companies such as Amazon, Apple and Tesla. In the past, however, there have been long periods where value investing has performed better.
Beyond value investing and growth investing, some alternatives eschew fundamental analysis completely. For example, those following a technical analysis approach that use past market data in an effort to predict future market prices. Likewise, day traders rely on short-term fluctuations in the market rather than an assessment of intrinsic value.
Value Investing with Mutual Funds
Mutual fundscan offer investors exposure to value investing. Most major fund companies offer both actively managed and passively managed (i.e., index funds) value funds. As an example, the Vanguard Value Index Fund Admiral Shares (VVIAX) invests in value companies. A simple comparison of this fund with the Vanguard Growth Index Fund Admiral Shares (VIGAX) underscores the difference in these two investment approaches.
The stocks comprising the value fund have an average P/E ratio of 18.1. The growth fund average P/E ratio is 38.8. Likewise, the P/B ratio of the value fund stands at 2.1, while the P/B ratio of the growth fund is 8.2.
As noted earlier, growth funds have outperformed value funds over the last several years, and this is reflected in the 10-year performance of these two funds. The value fund has returned an average 10.91% while the growth fund has returned 16.79%.
One should not, however, interpret this data as suggesting that growth investing is preferred over value investing. They both will have their day in the sun. If one were looking for a blend of these two investment styles, an would offer this approach.
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Final Thoughts
Value investing is a solid approach to building wealth. It focuses on fundamental analysis of a company and calculating its intrinsic value. From there, value investors look to buy solid companies at or below their intrinsic value. It’s not, however, the only sound approach an investor can follow.
