Value Investing
The term "value investing" is usually mentioned opposite another investment strategy, "growth investing." Really understanding the difference between the two strategies requires a little bit of investment theory.
The price of a stock (just like the price of any other financial instrument) is supposed to equal the present value of its future cash flows. "Present value" refers to the concept that a dollar today is worth more than a dollar next year. "Future cash flows" refers to the amount of cash your business generates - after interest expense, after taxes, and after capital expenditures, how much cash is actually available to shareholders?
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Explores the history and principles of value investing, and sets up guidelines for its successful application. Discusses where to look for underpriced securities, how to determine the intrinsic value of a stock, and alternative methods for constructing a portfolio that control risk without restricting investment return. |
Value Investing: From Graham to Buffett and BeyondValue investing and growth investing differ in the pattern of expected future cash flows of the company. Value investing involves investing in established companies that are projected to have basically stable or slightly growing cash flows. Growth investing involves buying stock in companies that are projected to grow much faster than the market as a whole - and paying a premium for those companies. The projected cash flows of growth companies are much bigger, but much further away, and hence usually riskier.
Some investors prefer the simplification that "value investing" means investing in companies with low P/E's (price-to-earnings ratios, a proxy for the amount of cash flow a company is producing) - usually under 10.0x. "Growth investing" means investing in higher P/E companies. Underlying the high P/E is the concept that an investor is paying upfront for expected growth.
It is impossible to mention "value investing" without also mentioning Warren Buffett. Buffett doesn't consider himself a value investor, but the things he watches for in investing: a solid business model, competent management, and an excellent price - are all worth watching for in your own forays into value investing.
The first thing Buffett looks for is a tried and true business model. That means a company must have established its line of business, competed successfully within its industry, and produced reliable profits for its investors year over year. Whether the business is airplane manufacturing or clothing retailing, a strong history of profits is the clearest way to demonstrate that a company's way of doing business will withstand the challenges of time. Most value investors like to target companies that have had consistent histories of profit for the past three to ten years. Looking exclusively for historically profitable businesses protects the value investor from the risks that new and unprofitable businesses represent.
The next thing to look for in a value investment is a competent, ethical management team. Ordinary investors may not have the opportunity to meet management face-to-face, but value investors can look for other ways to gain insight into a management's priorities, such as by reading the Company's "letter to shareholders" in its annual report and listening to company earnings conference calls. Value investors seek out managements that are focused on shareholder interests and capable of delivering excellent results.
If you have a stable, profitable business and a competent management team, then you're ready to move to the third critical pillar of value investing, "an excellent price." As mentioned above, value investments are usually considered those with P/E's below 10x. Ask yourself this: would you be willing to spend $10 today to earn $1 each year, every year into eternity? With a stable business, this is exactly the concept that a P/E of 10x symbolizes.
Value investing doesn't appeal to everyone. Rather than talking with friends about the latest hot medical device patent or IPO, value investors must invest time and effort looking for the best companies in traditionally stodgier industries. Rather than gleefully anticipating 30%+ returns, value investors must remain focused on the long-term cash-generating power of their portfolios. However, for investors looking to build long-term wealth in the stock market, a value investing approach will go a long way.
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