Value Investing 101

An Introduction to Value Investing – What is Value Investing?

Australians getting ready to take the lead into share market investing are often lured there by the siren song of rewards “shooting to the moon.” They soon learn with those rewards, comes risk. The adage is the greater the rewards, the greater the risk.

It does not take long before they learn there is a class of stocks with less risk to the investor at the expense of lower rewards. The high reward/high risk stocks are considered growth stocks, while the less risky are called value stocks.

Stock prices are driven not by the present and future worth of the company but by market perceptions of that present and future worth. If the Aussie investing community believes a stock has substantial future potential they will rush in to buy and buy again, driving up the price.

On the other side you have companies the market community has little faith in, so the lower demand for a stock of questionable value drives down the price.

A true value stock is one about which the market is dead wrong, failing to see and appreciate the intrinsic value of the stock. In short, value stocks are underestimated and represent bargain opportunities for investors who know how to separate the wheat from the chaff. Eventually, investors who favor value stocks believe the market will catch on and begin to buy into the company once its value goes from perception to reality.

Value stocks are in effect, “on sale” attracting investors who believe just as if you buy a major appliance on sale or at full price, the appliance is the same.

While the price of the stock may rise and fall based on market perceptions, the reality of the company’s fundamentals and future opportunities remain the same.

US investor Benjamin Graham is credited with creating the value school of investing in the 1930’s with one of his disciples – Warren Buffet – holding title as one of history’s greatest value investors.

How to Find Good Value ASX Stocks

In theory, who could argue with this approach? Provided investors have the patience to wait for the market to stop understating a stock, why aren’t all investors following the value approach?

In practice, determining true intrinsic value can be a daunting task, with veteran investors like Buffet using a complicated discounted cash flow (DCF) analysis to spot value stocks.

However, retail investors do have readily available analytical tools at their disposal to guide them towards a sense of a company’s underlying value.

Financial websites, stock screeners, and quality online trading platforms provide professionally calculated metrics at the ready, beginning with the favorite of the majority of investors – the price ratios.

These ratios compare the stocks trading price against its earnings, sales, assets, and cash flow.

The Price to Book (P/B) ratio is the eye popper that jumps off the page. The ratio divides the current stock price per share by its book value per share, with ratios under 1.0 pointing to a stock selling for less than its worth.

The Price to Earnings (P/E) and Price to Sales (P/S) also start with the current price per share divided by earnings per share and sales per share.

Price to Cash Flow (P/CF) compares the stock price per share to the company’s generated cash flow per share.

All ratio need to be compared to companies with similar business models operating in similar industries. In all cases, lower ratios are essential, with P/Es under 10.0 and P/Bs under 1.0 providing a “gold standard.”

A dedicated value investor does not stop with the valuation price ratios, extending the search to include historical financial statements, a multitude of other ratios (return on equity, debt to equity, operating efficiency and more.)

A full analysis of a stock extends beyond the quantitative numbers into the qualitative aspects of a company – from the management to the employees and the customers.

Value investors have been dubbed “contrarian” for their tendency to ignore the temptation to follow the herd flocking to what they believe are overvalued stocks.

Growth vs Value

Growth stocks represent the flip side of value stocks. Typically growth stocks have readily available valuation metrics suggesting investors are paying more for the stocks than justified by their intrinsic value. The lures are many – operating in a hot sector; earning the accolade of “next big thing” stocks; revolutionary and disruptive products in the pipeline, and more. Market participants are convinced the upward march in the stock price will continue uninterrupted and flock to their trading platforms to buy. The rise in the stock price of a growth can be meteoric, but so can the fall.

Growth stocks are characterized by high valuation metrics, indicating investors are more than willing to pay an inflated price for the stock in the belief the future knows no bounds.

The Pros and Cons of Value Investing

The ‘pros” of value investing can best be summarised with the statement “who doesn’t love a bargain.”

The “cons” can be summarised by the challenge in accurately differentiating between those stocks whose lagging share prices are due to market underestimation of their true value and those whose stock prices is lagging for fundamental reasons.

The time-honored valuation measures need clarification. What is the time frame for the earnings, sales, and cash flow numbers used in calculating the ratios? Does the book value include intangible assets like “goodwill?”

The single biggest “con” is the value trap. Investors who stop their analysis with attractive P/E, P/B,P/S, and P/CF ratios are more subject to falling prey to value traps than those who continue to look for some signs that could disclose the trap.

Perhaps the most significant sign is inconsistency in financial performance of revenue and profit generation over time. A fundamentally sound company should show a consistent pattern of revenue growth and profit improvement, even in cases where results show an improvement in the losses posted by the company.

Cost control is another sign. Start-ups are expected to show increasing costs required to get their products or services into the market, but some promising companies can burn through available cash at alarming rates.

Poor management can be seen in failure to have in place a timeline for product development, market entry, marketing efforts, and a pipeline for future growth.

Aussie investors looking for bargains gravitate towards the value investing strategy. The core of the approach is to find stocks the overall market is largely ignoring for reasons other than the fundamentals of the company. The price of a value stock lags behind the intrinsic value of the company. The challenge for the investor is to determine the intrinsic value. There are a variety of tools available to aid investors in making that assessment.