What is Value Investing?

When you talk of value investing, what is the first name that comes to your mind? Your answer obviously would be Warren Buffett. But long before Warren Buffett entered the scene, and this has been acknowledged by Buffett himself, it was Ben Graham who came up with the idea of value investing.

At a conceptual level, value investing is a method of identifying a value proposition in any company which becomes the basis of investing. Value investing is based on the premise that every company derives its value because it can generate cash flows. Yes, there are other sources of value too like asset value or brand value. But the principal premise of value investing is that value comes from the ability of the business to generate consistent cash flows over some time.

Important Aspect of value investing

Once you have decided that a company will earn good cash flows in the future, what do you do? Value investing dictates that you discount cash flows to the present and calculate the value of the future cash flows. That is the intrinsic value which is one of the most important concepts in value investing. Now we come to the most important aspect of value investing, which is to identify stocks that are divergent from the intrinsic value. What does that mean?

Let us specifically look at what is value investing in stocks? It is the process of identifying companies that are trading at a substantial discount to the intrinsic value. This is the base for the investment decision. Of course, value investing does not tell you blindly buy stocks that are well below the intrinsic value but you have to look at a plethora of other factors too before making a decision.

Let us now move to two important aspects of value investing which are undervaluation and overvaluation. Value investing is about looking for a stock that is undervalued, which means it is trading at a price lower than its intrinsic value. On the other hand, value investing also tells you to sell a stock that is trading at a price that is way above its intrinsic value. Such stocks are also considered to be overvalued.

Let us understand a very important aspect of value investing here. Remember, value investing does not see that the stock price will immediately move towards intrinsic value. But eventually, the price will move towards the intrinsic value. The earlier the bird you are to get the worm, the more under-priced will be the stock. Once the whole market realizes the story, it will not be undervalued for too long as demand will exceed supply. Hence value investing is not only about buying with a margin of safety, but also buying before the market can see the trend. That is the crux of value investing.

Will you gain by buying stocks that are trading well below their intrinsic value? The principle behind value investing is to buy stocks when they are undervalued and to sell them when they are overvalued. That is where Buffett spoke at length about the margin of safety. This is the gap between intrinsic value and market price. The greater this positive gap, the better it is for value investing.

Does value investing in India work? The answer is value investing in India or value investing globally, which is an idea that is based on the pure logic of buying underpriced assets. Remember, as we often get to see in Indian markets, stock prices are volatile and therefore they can change owing to several reasons. But all these fluctuations are opportunities. For example, you found HDFC Bank valuable at Rs.1250. Due to a correction in the banking stocks, HDFC Bank falls to Rs.1000. As per value investing theory, it has become more attractive. That is what is value investing in stocks for you.

Now let us move to a very important question, how do you derive this intrinsic value, which is so basic to value investing. You need to look at the future growth of the company, the earnings potential if the industry is disruptive, etc. Value investing covers, among other things, the company’s financial history, revenues, and cash flows over the years. It also looks in detail at the business model, profits, future profitability, and sustainability of the business model under stressful conditions.

Value investing is about finding out value. Hence you must also look at it from the other side. Value investing is also about avoiding factors that destroy value. Be cautious of companies that take on too much debt, companies that default on compliances, companies that have weak corporate governance levels, or companies that are spending more than they earn. These are all value destroyers and red flags for value investing. There are enough cases in India where too much debt and weak corporate governance have been the reasons for companies faltering.

Can you do value investing in loss-making companies? It is a tricky question, but it is possible. If the business model is sound and you have visibility of cash flows, then value investing principles can also be applied to loss-making companies. In such cases, you use the EV/EBITDA ratio instead of the P/E or P/BV ratio. The idea of value investing is still the same; whether there can be value generated through cash flows?

Let us spend a moment on the discounted cash flow or DCH method, which is an important aspect of value investing. In this method, the future cash flows are predicted for the next 4-5 years and then they are discounted to the present using the cost of capital to discount cash flows. This is an important step in value investing.

Finally, let us look at why value investing is advantageous. Firstly, it reduces your risk as an investor. When you buy a stock with intrinsic value, you will end up making money in the long term if not in the short term. It is like protection for your capital and a promise of wealth creation. Secondly, if you look at long-term wealth creation, the only method is value investing. Only if you buy deeply undervalued stocks and hold them for the long term, you can create wealth through equities.

Difference between intraday and delivery trading?

In an intraday trade, you buy and sell on the same day. Either, you buy and close the long position or you sell and then close the short position. Either way, your net position at the end of the day is zero. Profits or losses in the intraday trades are adjusted to the trading account. There is no concept of delivery in or from the Demat account in intraday trading.

The converse to that is the delivery trade. If you don’t close the trade intraday, it becomes a delivery trade. So, if you buy and don’t square off intraday then you need to pay the full value of the purchase and take the shares into your Demat account. On the other hand, if you sell and don’t square off, then you have to give stock delivery.

How to pick stocks for long-term investment?

Value investing suggests that you can pick stocks based on the P/E ratio or based on the P/BV ratio. P/E ratio is the relationship between a company’s share prices and the EPS. It shows how much the market is willing to pay for every rupee of earnings earned by the stock. The P/E ratio is also called the discounting ratio and sectors with high ROE and high growth tend to have high P/E ratios.

Another method used in value investing to identify stocks, especially in the financial sector, is the Price to Book or P/BV ratio. It signifies the relation between the per unit book value of a company’s assets and the per-unit share price. The advantage of book value is that it is normally hard to misrepresent and hence value investing suggests combining P/E and P/BV.

Frequently Asked Questions

What is price to earnings ratio?

The ratio of market price to EPS shows how much the market is willing to pay for very rupee earned by the company as earnings. It is also the ratio of market cap to net profits.

What is margin of safety?

It is the positive gap between the intrinsic value of the stock and the market price. The more the price is below the intrinsic value, more the margin of safety and better for value investing.

Difference between investing and trading?

Trading is buying and selling stocks for the short term while investing is buying and selling stocks for the long term.