A lot of us value guys find it interesting how not everyone is into value. Value investing is as old as the hills. It’s about buying something for less than what it’s worth. As Ben Graham has pointed out, one has to buy stocks like he buys groceries. We tend to buy groceries when they’re marked down/at a discount.
If you can buy high quality tomatoes for $2 vs a regular price of $5, you’re going to take up the offer. Similarly, if you’ve got a high quality company like AAPL selling for $60, a 60% discount from here, you’re going to buy it.
Value investing at the very core is buying stocks for under what they’re worth. It’s picking stocks for under what they’re worth. The difference between value and price is called the margin of safety, and the larger the margin, the better.
Now of course, the immediate thing that comes to mind is- how does one figure out value?
It’s a good question.
It’s a good question because one, it’s the most important question in investing and two, it doesn’t have a fixed answer.
To figure out a precise value for a company and making it objective is an exercise in futility. There are three key ways that are used in figuring out value for a company.
First is the DDM or the Dividend Discount Model. This essentially values what dividends in the future are worth today. This is one of the earlier valuation models, where you forecast dividends into the future and discount them back at a discount rate, which helps adjust for the riskiness of the dividends.
Second is the DCF or the Discounted Cash Flow model. DCF is essentially a more advanced version of the DDM. DDM discounts dividends while DCF discounts cash flows to the company. Cash flow is what is left to a company after paying it’s employees etc. In other words, it’s the amount of cash generated by a company in a given period of time.
Third is the NAV model. NAV or net asset value is probably the simplest way to value companies. NAV was practiced by Ben Graham and in essence, you figure out what the value of a company’s balance sheet is and figure out how much that is relative to the stock price. Let’s use an example. Let’s say a company has $50 in assets and $10 in liabilities. This means that we have $40 in net asset value (assets-liabilities). If the company is trading for $30 right now, there is $10/$30 or a 33% margin of safety (as the difference between price and value is $10). This type of valuation can occasionally get more advanced.
Let’s move on to the second half of this post- why is value investing attractive?
Firstly, while value hasn’t had a good decade since the 2008 crisis, value has outperformed since 1942.
Secondly, most of the world’s greatest investors are value guys. Bill Ackman, Carl Icahn, David Einhorn and of course- Warren Buffett.
While value investing will continue to involve, keep in mind value isn’t for everybody. If it was, value wouldn’t work. Value requires some strong mental strength and willpower to buy beaten down stocks, and to buy things other people are selling.
It’s also something that either sticks with you or it doesn’t. As Buffett has said:
And with that, I’ll leave it to you. Do YOU have what it takes to be a value investor?
Categories: Financial Advice