What Is Value Investing?
Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. The overreaction offers an opportunity to profit by buying stocks at discounted prices—on sale.
Warren Buffett is probably the best-known value investor today, but there are many others, including Benjamin Graham (Buffet's professor and mentor), David Dodd, Charlie Munger, Christopher Browne (another Graham student), and billionaire hedge-fund manager, Seth Klarman.
Value investing developed from a concept by Columbia Business School professors Benjamin Graham and David Dodd in 1934 and was popularized in Graham's 1949 book, The Intelligent Investor.
How Value Investing Works
The basic concept behind every-day value investing is straightforward: If you know the true value of something, you can save a lot of money when you buy it on sale. Most folks would agree that whether you buy a new TV on sale, or at full price, you’re getting the same TV with the same screen size and picture quality.
Stocks work in a similar manner, meaning the company’s stock price can change even when the company’s value or valuation has remained the same. Stocks, like TVs, go through periods of higher and lower demand leading to price fluctuations—but that doesn't change what you’re getting for your money.
Just like savvy shoppers would argue that it makes no sense to pay full price for a TV since TVs go on sale several times a year, savvy value investors believe stocks work the same way. Of course, unlike TVs, stocks won't go on sale at predictable times of the year such as Black Friday, and their sale prices won’t be advertised.
Value investing is the process of doing detective work to find these secret sales on stocks and buying them at a discount compared to how the market values them. In return for buying and holding these value stocks for the long-term, investors can be rewarded handsomely.
- Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.
- Value investors actively ferret out stocks they think the stock market is underestimating.
- Value investors use financial analysis, don't follow the herd, and are long-term investors of quality companies.
Intrinsic Value and Value Investing
In the stock market, the equivalent of a stock being cheap or discounted is when its shares are undervalued. Value investors hope to profit from shares they perceive to be deeply discounted.
Investors use various metrics to attempt to find the valuation or intrinsic value of a stock. Intrinsic value is a combination of using financial analysis such as studying a company's financial performance, revenue, earnings, cash flow, and profit as well as fundamental factors, including the company's brand, business model, target market, and competitive advantage. Some metrics used to value a company's stock include:
Price-to-book (P/B) or book value or, which measures the value of a company's assets and compares them to the stock price. If the price is lower than the value of the assets, the stock is undervalued, assuming the company is not in financial hardship.
Price-to-earnings (P/E), which shows the company's track record for earnings to determine if the stock price is not reflecting all of the earnings or undervalued.
Free cash flow, which is the cash generated from a company's revenue or operations after the costs of expenditures have been subtracted. Free cash flow is the cash remaining after expenses have been paid, including operating expenses and large purchases called capital expenditures, which is the purchase of assets like equipment or upgrading a manufacturing plant. If a company is generating free cash flow, it'll have money left over to invest in the future of the business, pay off debt, pay dividends or rewards to shareholders, and issue share buybacks.
Of course, there are many other metrics used in the analysis, including analyzing debt, equity, sales, and revenue growth. After reviewing these metrics, the value investor can decide to purchase shares if the comparative value—the stock's current price vis-a-vis its company's intrinsic worth—is attractive enough.
Margin of Safety
Value investors require some room for error in their estimation of value, and they often set their own "margin of safety," based on their particular risk tolerance. The margin of safety principle, one of the keys to successful value investing, is based on the premise that buying stocks at bargain prices gives you a better chance at earning a profit later when you sell them. The margin of safety also makes you less likely to lose money if the stock doesn’t perform as you had expected.
Value investors use the same sort of reasoning. If a stock is worth $100 and you buy it for $66, you’ll make a profit of $34 simply by waiting for the stock’s price to rise to the $100 true value. On top of that, the company might grow and become more valuable, giving you a chance to make even more money. If the stock’s price rises to $110, you’ll make $44 since you bought the stock on sale. If you had purchased it at its full price of $100, you would only make a $10 profit. Benjamin Graham, the father of value investing, only bought stocks when they were priced at two-thirds or less of their intrinsic value. This was the margin of safety he felt was necessary to earn the best returns while minimizing investment downside.
Markets are not Efficient
Value investors don’t believe in the efficient-market hypothesis, which says that stock prices already take all information about a company into account, so their price always reflects their value. Instead, value investors believe that stocks may be over- or underpriced for a variety of reasons.
For example, a stock might be underpriced because the economy is performing poorly and investors are panicking and selling (as was the case during the Great Recession). Or a stock might be overpriced because investors have gotten too excited about an unproven new technology (as was the case of the dot-com bubble). Psychological biases can push a stock price up or down based on news, such as disappointing or unexpected earnings announcements, product recalls, or litigation. Stocks may also be undervalued because they trade under the radar, meaning they're inadequately covered by analysts and the media.
Don't Follow the Herd
Value investors possess many characteristics of contrarians —they don’t follow the herd. Not only do they reject the efficient-market hypothesis, but when everyone else is buying, they’re often selling or standing back. When everyone else is selling, they’re buying or holding. Value investors don’t buy trendy stocks (because they’re typically overpriced). Instead, they invest in companies that aren’t household names if the financials check out. They also take a second look at stocks that are household names when those stocks’ prices have plummeted, believing such companies can recover from setbacks if their fundamentals remain strong and their products and services still have quality.
Value investors only care about a stock’s intrinsic value. They think about buying a stock for what it actually is: a percentage of ownership in a company. They want to own companies that they know have sound principles and sound financials, regardless of what everyone else is saying or doing.
Value Investing Requires Diligence & Patience
Estimating the true intrinsic value of a stock involves some financial analysis but also involves a fair amount of subjectivity—meaning at times, it can be more of an art than a science. Two different investors can analyze the exact same valuation data on a company and arrive at different decisions.
Some investors, who look only at existing financials, don't put much faith in estimating future growth. Other value investors focus primarily on a company's future growth potential and estimated cash flows. And some do both: Noted value investment gurus Warren Buffett and Peter Lynch, who ran Fidelity Investment's Magellan Fund for several years are both known for analyzing financial statements and looking at valuation multiples, in order to identify cases where the market has mispriced stocks.
Despite different approaches, the underlying logic of value investing is to purchase assets for less than they are currently worth, hold them for the long-term, and profit when they return to the intrinsic value or above. It doesn't provide instant gratification. You can’t expect to buy a stock for $50 on Tuesday and sell it for $100 on Thursday. Instead, you may have to wait years before your stock investments pay off, and you will occasionally lose money. The good news is that, for most investors, long-term capital gains are taxed at a lower rate than short-term investment gains.
Like all investment strategies, you must have the patience and diligence to stick with your investment philosophy. Some stocks you might want to buy because the fundamentals are sound, but you’ll have to wait if it’s overpriced. You’ll want to buy the stock that is most attractively priced at that moment, and if no stocks meet your criteria, you'll have to sit and wait and let your cash sit idle until an opportunity arises.
Value investing guru Benjamin Graham argued that an undervalued stock is priced at least a third below its intrinsic value.
Why Stocks Become Undervalued
If you don’t believe in the efficient market hypothesis, you can identify reasons why stocks might be trading below their intrinsic value. Here are a few factors that can drag a stock’s price down and make it undervalued.
Market Moves and Herd Mentality
Sometimes people invest irrationally based on psychological biases rather than market fundamentals. When a specific stock’s price is rising or when the overall market is rising, they buy. They see that if they had invested 12 weeks ago, they could have earned 15% by now, and they develop a fear of missing out. Conversely, when a stock’s price is falling or when the overall market is declining, loss aversion compels people to sell their stocks. So instead of keeping their losses on paper and waiting for the market to change directions, they accept a certain loss by selling. Such investor behavior is so widespread that it affects the prices of individual stocks, exacerbating both upward and downward market movements creating excessive moves.
When market momentum and the herd mentality run to extremes, bubbles and crashes result. The early 2000s tech bubble and the mid-2000s housing bubble were fueled by over-investment that pushed up the prices of tech stocks and real estate beyond what the underlying companies and properties were worth. When the unsustainable highs began to fall, investors panicked, and a crash ensued.
Unnoticed and Unglamorous Stocks
Stocks might sell for less than they’re worth because they’re under the radar. Small cap stocks, foreign stocks, and any other stocks that aren’t in the headlines or aren’t household names sometimes offer great potential. Most investors want in on the next big thing such as a technology startup instead of a boring, established consumer durables manufacturer. For example, stocks like Facebook, Apple, and Google are more likely to be affected by herd-mentality investing than conglomerates like Proctor and Gamble or Johnson and Johnson.
Even good companies face setbacks, such as litigation and recalls. However, just because a company experiences one negative event doesn’t mean that the company isn’t still fundamentally valuable or that its stock won’t bounce back.
Sometimes a company has an unprofitable division that drags down its performance. If the company sells or closes that division, the company’s financials can improve dramatically.
Analysts do not have a great track record for predicting the future, and yet investors often panic and sell when a company announces earnings that are lower than analysts’ expectations.
Value investors who can see that a company's long-term value remains, they can buy the stock while its price is depressed due to bad news and analyst downgrades.
It’s common for companies to go through periods of higher and lower profits. The time of year and the overall economy affect consumers’ moods and cause them to buy more or less. Their behavior might affect the stock’s price, but it has nothing to do with the company’s long term underlying value.
Value Investing Strategies
The key to buying an undervalued stock is to thoroughly research the company and make common sense decisions. Value investor Christopher H. Browne recommends asking if a company is likely to increase its revenue via the following methods:
- Raising prices on products
- Increasing sales figures
- Decreasing expenses
- Selling off or closing down unprofitable divisions
Browne also suggests studying a company's competitors to evaluate its future growth prospects. But the answers to all of these questions tend to be speculative, without any real supportive numerical data. Simply put: There are no quantitative software programs yet available to help achieve these answers, which makes value stock investing somewhat of a grand guessing game. For this reason, Warren Buffett recommends investing only in industries you have personally worked in, or whose consumer goods you are familiar with, like cars, clothes, appliances, and food.
Another strategy involves buying companies whose products or services have been in demand for a long time and are likely to remain popular over the long haul. While it's difficult to predict when innovative new products will capture market share, it's easy to gauge how long a company has been in business and study how it has adapted to challenges over time.
Insider Buying and Selling
For our purposes, insiders are the company’s senior managers and directors, plus any shareholders who own at least 10% of the company’s stock. A company’s managers and directors have unique knowledge about the companies they run, so if they are purchasing its stock, it’s reasonable to assume that the company’s prospects look favorable.
Likewise, investors who own at least 10% of a company’s stock wouldn’t have bought so much if they didn’t see profit potential. Conversely, a sale of stock by an insider doesn’t necessarily point to bad news about the company’s anticipated performance — the insider might simply need cash for any number of personal reasons. Nonetheless, if mass sell-offs are occurring by insiders, such a situation may warrant further in-depth analysis of the reason behind the sale.
Analyze Earnings Reports
At some point, value investors have to look at a company's financials to see how its performing and compare it to industry peers.
Financial reports present a company’s annual and quarterly performance results. The annual report is SEC form 10-K, and the quarterly report is SEC form 10-Q. Companies are required to file these reports with the Securities and Exchange Commission (SEC). You can find them at the SEC website or the company’s investor relations page on their website.
You can learn a lot from a company’s annual report. It will explain the products and services offered as well as where the company is heading.
Analyze Financial Statements
A company’s balance sheet provides a big picture of the company’s financial condition. The balance sheet consists of two sections, one listing the company’s assets and another listing its liabilities and equity. The assets section is broken down into a company’s cash and cash equivalents; investments; accounts receivable or money owed from customers, inventories, and fixed assets such as plant and equipment.
The liabilities section lists the company’s accounts payable or money owed, accrued liabilities, short-term debt, and long-term debt. The shareholders’ equity section reflects how much money is invested in the company, how many shares outstanding, and how much the company has as retained earnings. Retained earnings is a type of savings account that holds the cumulative profits from the company. Retained earnings are used to pay dividends, for example, and is considered a sign of a healthy, profitable company.
The income statement tells you how much revenue is being generated, the company's expenses, and profits. Looking at the annual income statement rather than a quarterly statement will give you a better idea of the company’s overall position since many companies experience fluctuations in sales volume during the year.
Studies have consistently found that value stocks outperform growth stocks and the market as a whole, over the long-term.
Couch Potato Value Investing
It is possible to become a value investor without ever reading a 10-K. Couch potato investing is a passive strategy of buying and holding a few investing vehicles for which someone else has already done the investment analysis—i.e., mutual funds or exchange-traded funds. In the case of value investing, those funds would be those that follow the value strategy and buy value stocks—or track the moves of high-profile value investors, like Warren Buffet. Investors can buy shares of his holding company, Berkshire Hathaway, which owns or has an interest in dozens of companies the Oracle of Omaha has researched and evaluated.
Risks with Value Investing
As with any investment strategy, there's the risk of loss with value investing despite it being a low-to-medium-risk strategy. Below we highlight a few of those risks and why losses can occur.
Basing Calculations on the Wrong Numbers
Since value investing decisions are partly based on an analysis of financial statements, it is imperative that you perform these calculations correctly. Also, companies differ in their accounting methodologies, making it difficult to accurately compare different companies on the same financial metrics. If you aren’t confident in your ability to read and analyze financial statements and reports, keep studying or contact a financial advisor for help.
Overlooking Extraordinary Gains or Losses
Some years, companies experience unusually large losses or gains from events such as natural disasters, corporate restructuring or unusual lawsuits and will report these on the income statement under a label such as “extraordinary item—gain” or “extraordinary item—loss.” When making your calculations, it is important to remove these financial anomalies from the equation to get a better idea of how the company might perform in an ordinary year.
One of the biggest risks in value investing lies in overpaying for a stock. To reduce the risk, be sure to build a margin of safety into all your investments—buying stocks at a price of around two-thirds or less of their intrinsic value.
Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. As a result, diversification is important, which may involve owing multiple stocks or stock indexes to create exposure to a wide variety of companies and economic sectors. Value investor and investment manager Christopher H. Browne recommends owning a minimum of 10 stocks in his “Little Book of Value Investing.” Famous value investor Benjamin Graham suggested that 10 to 30 companies are enough to create a diversified portfolio.
Value investing, properly executed, is a low-to-medium-risk strategy. But it still comes with the possibility of losing money. This section describes the key risks to be aware of and offers guidance on how to mitigate them.
Basing Your Calculations on the Wrong Numbers
Since value investing decisions are partly based on an analysis of financial statements, it is imperative that you perform these calculations correctly. Using the wrong numbers, performing the wrong calculation or making a mathematical typo can result in basing an investment decision on faulty information. You might then make a poor investment or miss out on a great one. If you aren’t yet confident in your ability to read and analyze financial statements and reports, keep studying these subjects and don’t place any trades until you’re truly ready. (For more on this subject, check out our Advanced Financial Statement Analysis Tutorial.)
One strategy is to read the footnotes. These are the notes in a Form 10-K or Form 10-Q that explain a company’s financial statements in greater detail. The notes follow the statements and explain the company’s accounting methods and elaborate on reported results. If the footnotes are unintelligible or the information they present seems unreasonable, you’ll have a better idea of whether to pass on the stock.
Overlooking Extraordinary Gains or Losses
Some years, companies experience unusually large losses or gains from events such as natural disasters, corporate restructuring or unusual lawsuits and will report these on the income statement under a label such as “extraordinary item — gain” or “extraordinary item — loss.” When making your calculations, it is important to remove these financial anomalies from the equation to get a better idea of how the company might perform in an ordinary year. However, think critically about these items, and use your judgment. If a company has a pattern of reporting the same extraordinary item year after year, it might not be too extraordinary. Also, if there are unexpected losses year after year, this can be a sign that the company is having financial problems. Extraordinary items are supposed to be unusual and nonrecurring. Also beware a pattern of write-offs.
Ignoring the Flaws in Ratio Analysis Earlier sections of this tutorial have discussed the calculation of various financial ratios that help investors diagnose a company’s financial health. The problem with financial ratios is that they can be calculated in different ways. Here are a few factors that can affect the meaning of these ratios:
- They can be calculated with before-tax or after-tax numbers.
- Some ratios provide only rough estimates.
- A company’s reported earnings per share (EPS) can vary significantly depending on how “earnings” is defined.
- Companies differ in their accounting methodologies, making it difficult to accurately compare different companies on the same ratios. (Learn more about when a company recognizes profits in Understanding The Income Statement.)
One of the biggest risks in value investing lies in overpaying for a stock. When you underpay for a stock, you reduce the amount of money you could lose if the stock performs poorly. The closer you pay to the stock’s fair market value — or even worse, if you overpay — the bigger your risk of not earning money or even losing capital. Recall that one of the fundamental principles of value investing is to build a margin of safety into all your investments. This means purchasing stocks at a price of around two-thirds or less of their intrinsic value. Value investors want to risk as little capital as possible in potentially overvalued assets, so they try not to overpay for investments.
Conventional investment wisdom says that investing in individual stocks can be a high-risk strategy. Instead, we are taught to invest in multiple stocks or stock indexes so that we have exposure to a wide variety of companies and economic sectors. However, some value investors believe that you can have a diversified portfolio even if you only own a small number of stocks, as long as you choose stocks that represent different industries and different sectors of the economy. Value investor and investment manager Christopher H. Browne recommends owning a minimum of 10 stocks in his “Little Book of Value Investing.” Famous value investor Benjamin Graham suggested that 10 to 30 companies is enough to adequately diversify.
On the other hand, the authors of “Value Investing for Dummies,” 2nd. ed., say that the more stocks you own, the greater your chances are of achieving average market returns. They recommend investing in only a few companies and watching them closely. Of course, this advice assumes that you are great at choosing winners, which may not be the case, particularly if you are a value-investing novice.
Listening to Your Emotions
It is difficult to ignore your emotions when making investment decisions. Even if you can take a detached, critical standpoint when evaluating numbers, fear and excitement may creep in when it comes time to actually use part of your hard-earned savings to purchase a stock. More importantly, once you have purchased the stock, you may be tempted to sell it if the price falls. You must remember that to be a value investor means to avoid the herd-mentality investment behaviors of buying when a stock’s price is rising and selling when it is falling. Such behavior will obliterate your returns. (Playing follow-the-leader in investing can quickly become a dangerous game.
The Bottom Line
Value investing is a long-term strategy. Warren Buffett, for example, buys stocks with the intention of holding them almost indefinitely. He once said, “I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years.” You will probably want to sell your stocks when it comes time to make a major purchase or retire, but by holding a variety of stocks and maintaining a long-term outlook, you can sell your stocks only when their price exceeds their fair market value (and the price you paid for them).