Value investing is about finding stocks that the market has not correctly priced…in other words, a stock that is worth more than is reflected in the current price. Many people have made fortunes using a value-based approach to investing. Value investing has been proven to work well over time if you buy carefully and hold for the long term.
Value investing, perhaps more than any other type of investing, is more concerned with the business and its fundamentals than market factors or a stock’s price. Fundamentals include earnings growth, dividends, cash flow and book value.
If the fundamentals are sound, but the stock’s price is below its intrinsic value, the value investor knows that the market has incorrectly valued the stock and it is a likely investment candidate. When the market corrects that mistake, the stock should experience an increase in price.
Current accounting standards are adequate for measuring buildings and equipment (book value), but as our economy has moved to a more technology/knowledge-base, many of these intellectual assets never show up on financial statements.
Value investors acknowledge that their target investment company is much more valuable as an ongoing business (expected cash flows, etc.) than its assets (market value). In many cases, it is the intangibles—patents, trademarks, research and development, brand, and so on—that drives the expectations of future growth, not hard assets.
Coming up with the intrinsic value of a stock is a complicated process and there are a number of ways to get to the number.
To determine a company’s intrinsic value, the Benjamin Graham Value Investor calculates discounted earnings per share. This is calculated by projecting current earnings forward 10 years and discounting the forward earnings back to the present using the current 10-year Treasury Note rate of interest adjusted by the quality of the company.
In addition to a company’s intrinsic value, the Benjamin Graham Value Investor also considers a company’s historic value to determine its value. A company’s historic value is calculated from the 10-year history of prices relative to revenues, cash flow, earnings, dividends, and book value.
Margin of Safety
One of Benjamin Graham’s best-known factors in purchasing a stock was the Margin of Safety. This method of stock selection continues to be used by Warren Buffett and others.
Graham’s Margin of Safety simply means buying companies that are cheap relative to their intrinsic value. If a company can be bought at a significant discount to its intrinsic value, it is a good value. For example, if we believe the intrinsic value of a company is $40 per share, we apply a margin of safety and lower the target buy price to $36 per share.
Using Graham’s criteria, the Cabot Benjamin Graham Value Investor determines optimum Maximum Buy Prices and Minimum Sell Prices for stocks in order to achieve results similar to Benjamin Graham. These targets are listed in each issue of the Benjamin Graham Value Investor for every recommended stock.
Our target price is based on a combination of estimates derived from intrinsic value (discounted earnings per share) and historic value (derived from historic results of the company). The ratios are projected forward to derive an estimate for a current estimated Maximum Buy Price.
The Minimum Sell Price is based on a combination of estimates derived from discounted earnings per share and the 10-year history of prices relative to revenues, cash flow, earnings, dividends, and book value. Each stock is expected to reach its Minimum Sell Price within one to three years.