Value investing refers to the process of finding stocks that are selling at a price that is below the current value, or worth, of the company. These may be investments in companies that the market has overlooked or that have simply fallen out of favor, replaced with newer, ‘sexier’ stocks in the minds of investors.
Many investors have made their fortunes using a value-based approach to investing, including such notable investors as Warren Buffett, Benjamin Graham and many others. If you buy carefully and hold stocks for the long term, value investing can work very, very well.
Value investing focuses on the business and its fundamentals rather than market factors or the trajectory of the stock’s price. These fundamentals include metrics of the company’s performance, such as earnings growth, dividends, cash flow and book value.
If the fundamentals are sound, but the stock’s price is below its intrinsic value (i.e., what the stock ‘ought’ to be worth), the market has incorrectly valued the stock and it is a likely candidate for the value investor. Once the market realizes its mistake, it should drive the price up to the point where to stock is fairly valued.
So how do you determine the company’s intrinsic value? Well, it’s more difficult than it used to be, that’s for sure. Current accounting standards can accurately measure the value of buildings and equipment (book value). But intellectual assets, which are difficult to quantify and don’t show up on balance sheets, are becoming a greater part of the value of many companies.
Value investors know that any company is worth far more as an ongoing business than as just the sum of its assets. In many cases, the intangible assets—patents, research and development, intellectual property, brand, etc.—are the driving force behind expectations of future growth.
There are a number of ways to quantify a company’s intrinsic value. The formula used by the Benjamin Graham Value Letter calculates discounted earnings per share. Current earnings are projected forward 10 years, and forward earnings are discounted back to the present using the current 10-year Treasure Note rate of interest adjusted by the quality of the company.
Historic value is also calculated, and used with intrinsic value to determine a company’s overall value. Historic value is calculated from the 10-year history of prices relative to revenue, cash flow, earnings, dividends, and book value.
Margin of Safety.
Once you have determined a company’s intrinsic value, you need to compare it to the company’s market capitalization (stock price times number of outstanding shares). Then look for the Margin of Safety.
The Margin of Safety is a concept Benjamin Graham pioneered to represent the difference between the value of a company and its stock price. A Margin of Safety means that a company is ‘cheap’ relative to its intrinsic value; it can be bought at a discount. For example, if we analyze a company and determine that its intrinsic value is $40 per share, we then apply the margin of safety and determine that $36 per share is the most we should pay for the stock.
That $36 per share figure becomes the Maximum Buy Price. As value investors, we will wait until the stock drops below that price before we purchase it. (Of course, if it’s already there, we can jump right in!) We also need to identify a Minimum Sell Price, the price we need the stock to reach before we sell it. This will typically be close to the intrinsic value, but may be higher if the company has the potential to grow. Most stocks are expected to reach their Minimum Sell Price within one to three years.
This system for value investing, developed by Benjamin Graham, utilized by Warren Buffett and espoused in the Cabot Benjamin Graham Value Letter, when applied with discipline and patience, can produce exceptional returns in any market, with any amount of money.
J. Royden Ward is Cabot’s Value Investment Specialist and Chief Analyst of Cabot Benjamin Graham Value Investor. He is also a regular contributor to Cabot’s free e-newsletter, Cabot Wealth Advisory.
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