Value Investing - What is Value Investing & its Fundamentals

Value investing is the dark horse of stock markets. And this dark horse has created huge wealth for none other than Warren Buffet. Read on to know what value investing is, and what are the critical factors in this strategy.

All that glitters is not gold and all that is gold does not always glitter. This holds true for investment decisions as well and forms the core principle of value investing.

What is Value Investing?

The value investment strategy was popularised by Benjamin Graham along with David Dodd after successfully surviving the period of the great depression. It involves proactively identifying stocks which are trading at a significantly lower value than their intrinsic value. Intrinsic Value refers to the true value of a stock.

The two factors behind value investing are market price and value. Price is the amount you pay, and the value is what you get in return. Value investing believes that the stock market does not always remain in an efficient or balanced state. It sometimes overreacts to events such as political announcements, organisational restructuring, economic conditions and results in stock price fluctuations which do not correspond to the company’s actual worth or long-term fundamentals. Hence, there is a good probability that there are undervalued or overvalued stocks in the market.

Value Investing and Behavioral Finance

Value Investing and Behavioral Finance are two sides of the same coin. Value investing aims to exploit irrational or impulsive behaviour of investors. Emotions heavily influence investment-related decisions. Greed, fear, peer-pressure lead to poor investment decisions. This creates a huge potential for dispassionate or objective investors. Value investors do not get carried away by market sentiments or herd mentality, instead, they look at the real value of a stock in the long run. They also do not fall into a “growth trap” without actually understanding the history or behaviour of stocks.

Fundamentals of Value Investing1. Find the intrinsic value

Investors who follow value investing strategy are more interested in a stock’s intrinsic value and not just the current market price. There are multiple ways and valuation methods that are used to identify the intrinsic or true value of a stock. Such as discounted cash flow analysis, dividend discount model, Earning per Share valuation, etc. There is also a formula coined by Benjamin Graham to arrive at the true value of a stock. It is:

Intrinsic Value = Earnings Per Share (EPS) multiplied by (8.5+ Twice the growth rate of the company in the coming 7-10 years).

This formula has been now tweaked to reflect the current market conditions correctly. It is now:

Intrinsic Value = [Earnings Per Share (EPS) multiplied by (8.5+ Twice the growth rate of the company in the coming 7-10 years) multiplied by 4.4] divided by current corporate bond (AAA) yield.

4.4 in the above formula referred to the minimum rate of return in the USA in the year 1962. For the purpose of valuation of Indian stocks, 4.4 should be replaced by the corporate bond yield in the same year in India.

When the stock’s market value goes below the calculated intrinsic value, investors purchase those stocks. Then they sit back and relax till the time the market corrects itself and the stock price reaches its actual value.

2. Margin of Safety

Margin of Safety enables value investors to manage risks and avoid losses. It is also the key element which distinguishes value investing from mere speculation. It refers to the difference between the stock’s current market price and its intrinsic value. Higher the gap, greater is the safety margin. By investing in a stock with an adequate security margin, investors know that any negative event or volatility will not adversely impact the value of the investment.

3. Don’t follow the crowd

Value investing is not for those who like to follow the herd. Value investors focus on stocks which are overlooked or avoided by others because of their low valuations but are inherently solid stocks.

Are there risks in Value Investing?

Yes. Just like all the other things in our life, there are risks involved in Value Investing as well. One of the biggest risks is falling into Value Traps. All cheap stocks do not translate into good investment decisions. Value traps are stocks which seem to cheap due to low PE multiple or cash flows, but never go up in value. It is important to do full due- diligence before investing. This includes not just financial metrics, but also qualitative aspects such as quality of management, stability, competition, etc.

Final Words

Value investing is a proven strategy for wealth appreciation in the long run. But it can be an intimidating way of investing without the right support. A partner like IndiaNivesh can make the process smooth and more fruitful for investors. IndiaNivesh is a reputable financial service provider which offers a wide range of services related to Broking, Institutional equities, strategic investments, wealth management, investment banking and corporate finance. With their in-depth understanding of the Indian markets, the organisational experience of three centuries and cutting-edge technological tools, they help investors make well-informed and profitable decisions.Disclaimer: "Investment in securities market and Mutual Funds are subject to market risks, read all the related documents carefully before investing."