One day you go out for shopping and find that your favorite brand has a discount sale that is going on, the first thing that you want to do is buy it with the simple reason ‘You are getting a quality product at a low price’. Suppose the price of the product is Rs. 1000 and during the sale, the product is priced at Rs 800. You will think it is a profitable deal as you are getting the product at Rs. 200 discount. And value investing teaches us to buy stocks similarly.
What is Value Investing?
In other words, value investing is an investment strategy in which stocks are bought at a discount and such stocks are known as undervalued stocks. There are three basic concepts that one needs to know to understand value investing.
How Does it work
- Price and Value
Price and value are two different aspects, they are not the same. According to value investing a stock has Intrinsic value which depends on the company’s financial strength and future growth whereas the stock price of the company depends on the market. And the intrinsic value of the stock can be less, greater or equal to stock price. The Indian market has around 5000 companies and the companies that are in news are usually traded at a higher price whereas the companies that do not make it to the news are traded at a lower level and hence remain undiscovered.
For example, there are three stocks A, B, and C.
The stock price A is 100, intrinsic value is 90. The Stock price > Intrinsic Value is overvalued.
The stock price of B is 90, intrinsic value is 100. The stock price < Intrinsic Value, it is undervalued.
The stock price of C is 100, Intrinsic value is 100. The stock price= Intrinsic Value, it is at par.
In value investing we have to find stocks such as B, meaning their stock price is less than the intrinsic value.
- Change in the stock price
It is generally assumed that the more volatile a stock is, the more risk it is, but as per the concept of value investing the more the movement in stock price, the more the price of the stock changes and the more it allows us to buy undervalued stocks and buying undervalued stocks is less risky as we get the stock at a discount.
- In the long-term Stock price of a company will follow its intrinsic value
In the short term, the price of the stock can be more or less than the intrinsic value but over the long period, the stock price will follow the intrinsic value. For example, you bought two stocks X and Y, the intrinsic value of a stock is Rs 100, but the current price of the stock is Rs 50 as per the theory the price of the stock will follow and become Rs 100. Whereas the intrinsic value of Y is Rs 80 but the current price of the stock in the market is Rs 120, over the long run the price of the stock will come towards 80. In other words, the price of the stock over the long run will move around the intrinsic value of the stock.
Having said that, the investment technique has worked for many great investors such as Warren Buffet, who has borrowed the concept from Benjamin Graham but finding the intrinsic value of a company requires time and patience. There are some techniques of calculating, let’s look at some of the ways for calculating intrinsic value.
Value Investment Strategies
Let’s take an example of a private company whose market value is not available. It is located in your village and sells bakery products. The company is located at a prime location and has been existence in business for more than thirty years. Because of this, the company has many customers who buy its products regularly. The owner decides to sell the company and you want to buy it, since there is no market price available you have to decide the value of the company.
So, the first thing that you do is analyze and read the financial statements of the company and see whether the company is earning profits consistently.
The next thing you do is go into the market and do some research about the products and quality and how they are perceived by the customers. And you find out that the products are trusted by customers and hence they prefer going to the shop regularly. So, from this, you can say that the company is earning profits regularly and will continue to earn in the future, and here you have done your quality analysis.
Now you have to calculate the intrinsic value of the company. The company is earning 10 lakhs every year and the customers do take a lot of credit meaning that the earnings are directly converted into cash and this is known as cash flow from operations. And since the company is not very risky you are satisfied with an average return of around 14%. So you calculate the intrinsic value by:
Earnings (10 lakhs)/ Required Rate of Return (14%)
= 10,00,000/ 0.14
= Rs 71,42, 857
This means that you bought the company at Rs 71 lakhs and the company's profit will be yours. The company earns a profit of 10 lakhs and every year you receive 14% of Rs 71,42,857 which is 10 lakhs and this is the profit that you will earn every year and this method is known as Discounted cash flow (DCF) valuation method. In this, you are discounting all the company's future cash flows, and bringing to the present value.
Price to Earnings (P/E Ratio)
It is calculated by dividing the price of the company by the earning. The price of the company is 71 lakhs and 10 lakhs is the earning.
Price (71.4 lakhs)/ Earning (10 Lakhs)
Which means that you will recover your investment in 7.14 year or in other words you are paying Rs 7.14 in advance to earn Rs 1. As an investor of value investing, you should look for companies that have lower P/E ratios. A lower P/E ratio will mean that you are buying the company at a lower price.
These are some of the methods of finding the intrinsic value of the company. And these are some of the strategies for doing value investing. And to end this article with a Warren Buffet Quote “ Price is what you pay and Value is what you get”.