Understanding Value Investing

One of the beautiful things about the world of investment is that it’s deeply personal, and everyone can have an individual flavor. You only invest in what interests you, and even if that is something that others are interested in, the factors that drove you may not be what drove another person.

Investing is always about being strategic, and you need to define your own strategy prior to getting involved in it so that you’re not just blindly throwing money about the place.

While growth investing is one of several such strategies that are very popular, there is much merit in what may be considered the opposite. This is value investing. This strategy requires a good eye and an even better understanding of value. Why is this? Unless you can accurately assign a value to stocks that have a different market value, then you may not be able to pull this one off.

How Value Investing Works

The workflow of value investing is simple in explanation. All you need to do is to be able to identify stocks that you believe have an incorrect market value. More specifically, you must be able to identify stocks that the market values below a figure that you consider to be correct.

Though a good eye was referenced above, it means more than just the ability to look at a stock and make a guess. While you are guessing, there is work that goes into this guess, considering that you are using a stock’s intrinsic value to make your call.

The intrinsic value of a stock is simply your perception of it based on a simple formula. This formula includes finding the difference between the listed price of the stock and the option’s strike price. When you get that figure, you then need to know how many shares you can buy based on your options. Those two figures are then multiplied to give you your final answer. The formula can be expressed as follows:

  • Number of options x (listed stock price – option’s strike price) = Intrinsic Value

To help you better understand, consider the following example using figures. Imagine that there is a stock that is trading at $50 per share. Imagine also that you are currently the owner of five call options, which allow you to purchase 200 shares at a price of $40.

To find the intrinsic value, you can substitute the descriptions in the formula above for the figures, which results in the following:

  • 800 x (50 – 40) = $8,000

The exceptions to this rule are those stocks that have a share price that is less than the strike price. These stocks are known as being “in the money,” and they do not hold any intrinsic value.

Once you have this intrinsic value, you can assess it using an appropriate valuation method, such as a discounted cash flow analysis. Once you’re done, then all you do is compare the resulting value with the price of the stock.

You purchase the stock if the intrinsic value exceeds the market value by some amount that was pre-determined. This difference is known as the stock’s margin of safety.

You can view this in the same manner as you would buying an item that’s on sale. Of course, this does not include false sales that cut prices that were artificially inflated. For this example, you would need to consider items that are truly on sale, where there is a discount applied to the actual value of the item. Purchasing it during such a sale means that you save. You could even choose to resell this item at the full value once that sale is over.

The reason that this approach works with stocks is that the market value associated with them can move in a similar way. This means that you end up with a situation where the stock price becomes different from the stock’s true value. The demand for a stock is a huge driver of this price.

Why would you ever pay for something at full price when you know that there are times when it goes on sale? Would you not wait until that sale is taking place? Of course, the process isn’t that black and white with stocks, since there’s no way to identify a time in the year when you know a stock falls in price before it appreciates again.

This is the reason for the mathematical analysis techniques used in value investing. You are required to locate these sales on your own. Once you get it right and you keep these stocks for the long-term, you usually stand to gain quite a bit.

The Efficient-Market Hypothesis

This hypothesis, which is affectionately known as EMH, states that there is no way to achieve consistent alpha generation and that share prices adequately reflect the correct information. Therefore, it assumes that the value which a stock carries on an exchange is always a fair one.

Therefore, investors cannot sell stocks at an inflated price, nor can they purchase stocks that are undervalued. This would, therefore, mean that outperforming the stock market is impossible, even when strategies, such as market timing or expert stock selection, are employed.

What this translates to is that only the purchase of risky investments can yield higher returns for investors, so the concept of purchasing a stock that is “on sale” doesn’t exist.

Clearly, this contradicts everything that value investors are about, and so they don’t believe in it. Instead of subscribing to this theory, value investors believe that there is always the potential for a stock to be valued too high or valued too low for a variety of reasons.

One such reason is panic. If you’ve watched the stock market for any significant amount of time, you would’ve seen the response to bad news. Sometimes, there is less than favorable news that emerges about a stock, and investors start to panic and sell the stock in a frenzy. This is one of the factors that contributed to the Great Recession. This is an instance in which you could count a stock as being undervalued.

On the flip side, stocks can become overvalued when investors get too excited. Think back to the dot-com bubble, for example. There was a new technology on the horizon, and investors began to purchase the stock in a similar frenzy, though the technology that was driving the purchasing decisions was yet to be proven. Of course, this doesn’t mean that the technology must turn out to be bad, but such excitement in something that is yet to have logical merit is misplaced.

Value investors believe that there are many possible influences and sources of psychological bias that factor into investment decisions. Therefore, news such as product recalls can cause stocks to become undervalued. It is also possible for stocks to not get enough coverage from the media or analysts. Therefore, they become undervalued by virtue of a lack of exposure.

The Value Investing Mindset

Many people call value investors contrarians. That description is not misplaced, since such persons don’t act based on the behavior of the rest of the market. Of course, the motivation behind doing so has nothing to do with simply a need for conflict or to be different. It is a mindset that is based on meticulous observation and acting in the most efficient way that they see fit.

When the rest of the market is selling a stock, these investors tend to be purchasing or holding it. Similarly, when everyone else is buying a stock, they are often seen selling it or doing nothing.

The core principle is to buy a stock based on what it really is, which is a part of a company.

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