The Complete Guide to Value Investing for Beginners

What is Value Investing?

Value investing is an investment strategy that seeks to take advantage of a discrepancy between an asset’s price and value.

Value investors search for issues trading at a discount to their intrinsic value.
In the stock market, though, things aren’t labeled as on sale.
Finding the right value stocks is often the result of extensive systematic work.

The stock market is probably the only market in the world where customers care so little about prices.
When buying stuff like a new TV, most people will research for hours trying to find the best one for the best price.

Yet when it comes to selecting investments, things that can substantially impact your future, no research is being conducted. All that is required for a purchase is a tip from some guy at work.
(The guy at work could also be an uncle, a father in law, or a friend. What they have in common is their inability to offer sound stock-advice.)

Value investors, though, see price as the key determining factor justifying an investment.

Table of Contents

Value investing vs. Growth investing

The problem with other investment strategies like growth investing is that you often pay a high price for the expected superior growth of an issue.
When the expected growth doesn’t come to pass, the price you paid isn’t justified and therefore declines.

By comparing the two strategies, you could see how value investing is less risky if done right.

Since you’re buying an issue for less than it’s worth, the business could suffer a decline in profits, and you might still make it out OK. (Depending on how cheap you bought the issue and the severity of the decline in profits.)

This room for error is called the margin of safety. It is the difference between the price you pay and the value you receive.
We will go over the idea more in-depth further down.

Does Value Investing still work?

Yes, if done right.
Imagine a time when buying something for less than it’s worth proves to be a bad strategy.
“I sure would like to buy this stock but it’s just too darn cheap!”
The real question isn’t whether value investing works or not, the question is how do you find the right stocks?
A question that will be answered further down the page.

One of the main things standing in the way of investors, keeping them from reaching their desired goals, is themselves.
Instead of looking at common mistakes covered here, we’ll look at the characteristics and qualities of successful value investors:

  • They are patient and not easily discouraged. It takes a certain type of person to stick to decisions once made, through thick and thin.
  • They are contrarians. Value stocks are often the forgotten and discarded stocks that no one else is willing to touch.
  • They are diligent. Finding value stocks requires hard and systematic work. You won’t find them dumped on the front page of the newspaper.
  • They don’t believe in the efficient market hypothesis which states that all information available is always reflected in the stock market prices. Therefore everything is always fairly priced and it would be impossible to beat the market.

Contrarian Investing and Value Investing

In essence, contrarian investing and value investing are the same, both look for mispriced issues undervalued by the market.
It should be self-explanatory that a stock is never cheap and popular at the same time so if you’re looking for value you can’t look where everyone else is.
That is the essence of contrarianism and value investing, going where the crowd isn’t.

Another thing that should be quite obvious, you can’t do what everyone else is doing and expect to get above average results.
But it’s different for me, you say, I can do what the majority is doing but better.
Unlikely. You might think you have the Midas’ touch when it comes to picking stocks.
You probably don’t.

Trying to beat the majority using their strategies becomes like that of Alice’s race against the Red Queen in the Alice in Wonderland sequel, in which Alice is running faster and faster but getting nowhere and the queen says:
You see, here we must run as fast as we can just to stay in one place. If you want to get somewhere else, you must run at least twice as fast as that!

The value investors, unlike the crowd, can’t hold back until the market encourages them. They must buy before the majority and then patiently wait for the market to realize the value.
If they’re  right in their assessment that there is some value not yet reflected in the price, the market will agree with them.
The only question is when.

The Core Ideas of Value Investing

What is Intrinsic Value?

When talking about stocks, the intrinsic value is the true value, as opposed to the market value.
The difference between the two:

• Intrinsic value is the value found from fundamental analysis, weighing both qualitative and quantitative aspects.
(Quantitative analysis involves analyzing numerical data, i.e, things understood in numbers. Revenue, profits, margins, assets, etc.
Qualitative analysis means analyzing data that can’t be understood in numbers. Things like the quality of the product or service the company provides, competition, market share, management, and so on.)

• Market value is what the market deems a stock to be worth.
The market value is the current stock price and the opinion of a myriad of people who each may or may not have conducted a fundamental analysis. Often not.
Therefore the market value tends to be over and undervalued.

The point of value investing is to take advantage of a potential discrepancy between these two values.

For example, let’s say you find the intrinsic value of a stock to be 100$ and the market price is 60$. That’s a 40% discount. Score!
That’s how it would work in theory.

In practice, no matter how careful, fundamental analysis won’t be able to pinpoint an exact intrinsic value. But that’s not the point either.

The point is only to establish that the intrinsic value is high enough compared with the price to justify a purchase.
In other words, it doesn’t matter if you can’t decide if the intrinsic value of a stock is 90$ or 110$ if the current price is 50$.

Or as Graham and Dodd put it in their book Security Analysis:

It’s quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.

How do you calculate Intrinsic Value?

The value of a business is based on how much profits it will generate going forward.
A common way of calculating intrinsic value is using the discounted cash flow method.

To better explain the DCF model, let’s start with a question:
Would you rather receive $100k today or $105k in a year?

To answer this, you need to assume what return you can achieve if you received and invested the 100k today.

If you can achieve more than a 5% annual return, taking the $100k today is worth it.

You can also reverse it. Assuming 5% is your annual return, $105k a year from now is worth $100k today.

This is known as the time value of money, a concept on which the DCF model is built on.
The concept states that money received today is worth more than the same amount received tomorrow.
How much more depends on what return you can achieve if you invested the money today.

Four Steps to Using the DCF Model to Estimate Instrinsic Value

Step 1.
You take this year’s cash flow and estimate the growth rate for the next five to ten years.
If the cash flows are $100m this year, assuming a 10% growth rate, next year’s will be $110m and so on.

Step 2.
You place a terminal value at the end of the estimated period.
Because even predicting growth for five to ten years is in most cases unreliable at best, estimating further into the future is a foolish endeavor. But since companies don’t just die after five years, you have to plug in a terminal value.
As a terminal value, you can either assume that A) the company will keep growing forever at a constant rate or B) the business is sold for a reasonable price.

Step 3.
You use a suitable discount rate to calculate how much the future cash flows and the terminal value is worth today. The suitable discount rate for investors using this valuation model is determined by the return they could have gotten had they invested their money elsewhere.
Assuming a 10% discount rate, $100m in 5 years is worth $62m today. After discounting all the cash flows and terminal value, you add them up and you will be left with the intrinsic value of the company.

Step 4. You compare it to the market value to see if there is a big difference. If the intrinsic value far exceeds the market value, it might be a worthwhile investment.

Important

The Discounted Cash Flow model of valuation is by no means without its flaws.

It requires making many assumptions, assumptions that need to be more accurate than might be possible. Small changes in these assumptions significantly impact the final value.

If paired with a careful fundamental analysis and using conservative estimates, it might prove useful. But in the end, it depends on the precision of your estimations.

Charlie Munger during a Berkshire annual meeting once said, referring to Warren Buffett:
For talking so much about discounting cash flows I’ve never seen him do a one even once”, to which Buffett replied jokingly:
some things you do in private, Charlie.” But then went on to explain that he never actually does one other than in his head, saying:
if you actually have to sit down and do one you’re cutting it too close.” 

Margin of Safety and the Speculative Component

If a stock’s intrinsic value is higher than its price, the difference is called a margin of safety. The term was first coined in 1934 in the book Security Analysis by Graham and Dodd.

When buying with a margin of safety, you leave room for unfortunate events or errors in your valuation. You also limit the downside risk of your investment. Since you buy something for less than it’s worth, its value could diminish without you necessarily taking a loss.

What if the stock’s price is higher than its intrinsic value?
In Security Analysis, Graham and Dodd suggested we call the difference a Speculative Component, a term that never seems to have caught on.
The speculative component is a premium the market has placed on the price. The premium can be justified by a company’s real but speculative possibilities or be the result of the market’s irrational behavior. Contrary to the margin of safety, the bigger the speculative component is, the greater the risk of investing.

side note

Graham and Dodd suggested there are two kinds of speculation:

  • Intelligent speculation. The taking of a risk that appears justified after careful weighing of the pros and cons.
  • Unintelligent speculation. Risk-taking without adequate study of the situation, i.e., Vegas-like gambling.

To summarize with an example, let’s say that you find the intrinsic value of a stock to be $50 per share that means if the price is:

  • $35, there’s a $15 margin of safety.
  • $65, there’s a $15 speculative component.

Value vs. Price

What causes stocks to trade at a discount to value?

The market tends to overreact, often to a short-term disappointment in profits or some other event, this sometimes causes a stock to drop way more than is justified.

Since the average stock market participator seems to invest in shorter and shorter term these overreactions are far from unusual.
This type of investor, ruled by emotion is always fearing that a falling stock will fall further and is more inclined to sell the further the stock drops.
They quickly discard stocks even if nothing fundamental has changed and then move on to other options that supposedly have higher probabilities in making them short term profits, this is rarely the case.

But the value investors see the fallacy of selling a stock the cheaper it gets.
If there is one fundamental principle of value investing it is doing the opposite.
While seemingly everyone invests in the short term the value investors are patient and ready to endure for the long run if needed because that’s where the real profits are and that’s their competitive edge over most others.

What causes stock prices to soar above what is justified?

Many, I mean seriously many transactions in the stock market are devoid of any basis in value.
The speculators base their purchases on the assumption that in the near future a greater fool will come along who is willing to pay more than they just did.
This greater fool assumes an even greater fool will come along.
This can’t go on forever. At some point, I know, hard to believe, the world will run out of greater fools.
The bubble then bursts and prices rapidly decrease.

If your appraisal of the intrinsic value is sound the margin of safety limits the downside risk of your investment.
It also leaves room for error in judgment and future unfortunate developments, the larger the margin of safety the greater the risk protection, i.e., the cheaper a stock is relative to its intrinsic value the less risk it is in buying it.

The speculative component is the premium the market has placed on the stock price.
A larger speculative component means greater risk and can also limit the upside depending on how large it is.
It can be justified by a business’ very real but speculative possibilities or the business’ or management’s supposedly superior quality or it can just be stock market irrationality.
Either way, without a margin of safety it can’t be called value investing.

How do you find value stocks

You will find them by hard and systematic work. It’s an excluding process in which you’re likely to go over and dismiss a multitude of stocks before finding something interesting. 

You won’t have to sift through every existing stock, though. You can use a stock screener to narrow them down. I recommend the free Yahoo Finance screener in which you can filter stocks by different ratios like:

Note, just because you can’t readily find an attractive issue doesn’t mean you should settle for a less than adequate one for the sole reason of being invested. Keep searching until you find one, an intelligent selection of the right stocks is crucial to your investment performance, no matter the strategy.

Finding a seemingly attractive issue is only the first step. The next step is to examine it further by conducting a fundamental analysis weighing quantitative and qualitative data.  

A critical step in fundamental analysis is comparing the company to others operating in the same industry. The point is to get a sense of the performance compared to similar companies and how they are valued.

A common mistake is feeling like you have spent too much time researching an issue to discard it. But always remember, a crucial part of intelligent stock selection is the exclusion of inadequate ones. So if you find a reason not to go through with an investment, don’t turn a blind eye to it.

If everything points to the fact that the stock price is unjustifiably low, though, it’s time to buy.

Buying a stock is easy. Holding it, while everyone is either selling or wanting no part in it, is hard.
Watching everyone else enjoy the rising prices of their stocks in a bull market while yours are at a standstill takes its toll. Yet, it’s what you should expect for long periods as a value investor.

Famous value investors

Benjamin Graham

Born in 1894 and working on Wall Street by the time he was 20. He is to the world of investing what Sir Isaac Newton is to the world of physics. 

Even though never using the phrase value investing in his classes or books, he is considered the strategy’s founder.

Author of the classic books Security Analysis and The Intelligent Investor. In the former, he laid the foundation to value investing and in the latter, solidified it. It was in these books he coined the terms margin of safety and intrinsic value.

Teaching legendary investors such as Seth Klarman and Warren Buffett, his impact on investing can not be exaggerated.

Warren Buffett

If Benjamin Graham is the Isaac Newton of investing because of his contributions, Buffett is the Michael Jordan because of his performance in the same area.

Renowned for his investment style, only caring about the performances of the businesses he owns, not about short-term fluctuations in price. He is often the first to pull out his wallet while everyone else is fleeing in panic during a stock market crash.
A great book highlighting his investment style is The Warren Buffett Way, written by Robert Hagstrom.

Taught by Benjamin Graham at the Columbia Business School, he later went on to work with him.
It’s easy to see how much of an impact Graham left on his investment philosophy, a fact Buffett himself states at every opportunity given.

But he also contributes his success to another titan in the field of investing, Philip A. Fisher. Also known as the author of Common Stocks and Uncommon Profits. Unlike Graham, Philip’s main focus was on so-called growth stocks.

Buffett himself has said that his style is 85% Graham and 15% Fisher.