Value Investing

What Is Value Investing?

Value investing is a strategy in which an investor looks for shares that appear to be priced below what the underlying business is really worth. The investor estimates a company's intrinsic value by studying its financial statements, then compares that estimate with the current stock price. When the market price is well under the estimate, the stock may be considered undervalued and a candidate for purchase. The approach is most closely associated with Benjamin Graham and David Dodd, whose book Security Analysis laid out many of its core ideas, and with later practitioners such as Warren Buffett.

How It Works

Value investors typically focus on measurable business characteristics rather than predictions about short-term price movements. Common starting points include:

• Low price-to-earnings ratio or price-to-book ratio compared with similar companies
• Steady earnings and healthy free cash flow
• A reasonable level of debt-to-equity ratio|debt relative to the business
• A dividend or other evidence of a company returning cash to shareholders

Because estimates of value are uncertain, value investors often leave a margin of safety. This means buying at a price comfortably below the estimated value, so that moderate errors in the analysis do not produce large losses.

Example

Suppose a company's assets and expected earnings suggest it is worth about 50 dollars per share, but its shares trade at 35 dollars. A value investor might see a margin of safety in that gap. If the market later recognizes the business's worth, the price could rise toward the estimate. However, the gap could also reflect real problems the investor has overlooked, and the price may stay low or fall further.

Advantages and Disadvantages

Value investing encourages patience, careful reading of financial statements, and discipline against paying high prices driven by enthusiasm. Its limitations include the difficulty of estimating value accurately, the possibility that cheap stocks are cheap for good reasons, and periods when value-oriented stocks lag growth-oriented ones for extended stretches. Results depend heavily on the quality of the analysis and the investor's time horizon.