To properly understand value investing, you must first understand the difference between price and value. The entire foundation of value investing lies on this principle, and it is the precept upon which Warren Buffett made his billions.
Price: The price in dollars at which you can purchase a security (be it a stock, bond, fund, or otherwise) on the open market. You can find the price of a security simply by typing its ticker symbol into Yahoo or Google finance, or the financial information website of your choice.
Value: The value in dollars of a security (be it a stock, bond, fund, or otherwise) that is available to purchase on the open market. Unlike the price, it can be exceedingly difficult to find the value of any given security.
As you may have already guessed, there is often a very significant difference between the price of a security and the value of a security. This difference has been attributed to many things—market irrationality, improper valuation methods by the market, market momentum, market manipulation, etc. Whatever the reason, a value investing strategy is predicated on exploiting this difference to make a profit—over the long run—in the market. Warren Buffett’s teacher, Benjamin Graham, often remarked that in the short run the market is a measure of popularity but in the long run is a measure of value. By this he meant that over the long run, the market will eventually price securities close to their underlying value, even if there are massive fluctuations in the short term.
So with all of that said, just how do you value a security? This article will focus primarily on stocks, as it is quite a bit easier to value publicly traded firms than, for example, bonds, funds, or derivatives.
Earnings. Otherwise known as income, this is the oldest metric by which the value of companies is measured. If you’ve spent any time at all dealing with stocks, you know about that pesky term “price/earnings.” This is a very simple statistic: it is the stock’s market price divided by its most recently measured annual earnings. In the most general sense, the lower the price is in relation to earnings, the better a deal you are getting. However, there are dozens or even hundreds of other factors to consider, including the quality of a firm’s earnings, future earnings, growth of earnings, sustainability, and so on. The historical market average P/E is approximately 15. However, the P/E ratio is notoriously unreliable to use as a metric during times of market turmoil, which are often the very best times to invest. As such, the primary question you need to address regarding earnings is: “Will this company earn money in the future? If so, will those earnings justify or more than justify its current market price?” If you can answer yes to both questions, you are likely making a good value buy.
Book Value. This is the company’s tangible value as determined by its balance sheet. To find this, you simply subtract the company’s total liabilities from its total assets. Some companies have a negative book value, while some companies have a book value far in excess of their price. Generally, a high book value is good, though you should only trust it if you have good knowledge of the company’s assets, liabilities, and how these things are calculated.
Intangible value. This encompasses dozens of different aspects, including branding, patents, market trends, quality of management, economic indicators, and so on. The very best value buys often have a very strong intangible value proposition.
Once you put these three things together, you can generally determine the value per share of a company totally independent of its market price. Once you’ve assigned a value to a company, you can then compare it to the market price. If it’s lower, you buy, and if it’s higher, you don’t buy or you sell it short. Because of stock market fluctuations, nearly every company in the history of western civilization has been a good value investing play at some point.
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