dapper grisly: Understanding Value Investing

by Jason Jenkins, Investment U Research
Friday, February 24, 2012

Understanding Value Investing

The case can be made that every investor should be a value investor. Who wants to invest in something that isn?t going to make them money or build wealth?

However, what I want to talk about is a specific philosophy that influences the way in which someone selects equities.

Value investing is a very popular stock-picking method. In the 1930s, Benjamin Graham and David Dodd, finance professors at Columbia University, laid out what many consider to be the framework for value investing. The concept is actually very simple: Find companies trading below their inherent worth.

Let me emphasize again, the method is not about second-hand generic shopping. Don?t pick junk. Yet, it?s about finding stocks that the market hasn?t correctly priced ? stocks that are worth more than what the market says their current price is.

The Underlying Business

The value investor picks his or her stocks based on the underlying business of that equity and its fundamentals, rather than other influences on the stock?s price. Primarily these fundamentals are such things as earnings growth, dividends, cash flow, book value, etc?

Also, keep in mind that value investors are ?buy and hold? investors. This isn?t a day trading approach ? it?s definitely for the long haul. That?s the only way it works because you need time.

If the fundamentals are sound, but the stock?s price is below its obvious value, the value investor knows this is a likely investment candidate. The market has incorrectly valued the stock. When the market corrects that mistake, the stock?s price should experience a nice rise.

What to Look For

Investors should settle on a formula that works for them, but it will probably include a minimum these six elements:

A price-earnings ratio (P/E) in the bottom 10% of its sector.
A PEG of less than one. By taking growth into account, the PEG ratio is widely considered a more accurate reflection of a stock?s true value, rather than just the P/E ratio. Using the PEG ratio is easy. A PEG of 1.0 means the market considers the stock to be fair value. A PEG under 1.0 means the stock is undervalued, while a PEG over 1.0 means the stock is overvalued.
A debt-to-equity ratio of less than one.
Strong earnings growth over an extended period. Some say a realistic range would be around 6% to 8% over seven to 10 years.
A price-to-book ratio of one or less.
Don?t pay more that 60% to 70% of the stock?s intrinsic per share price. (A big challenge for the value investor, and all investors for that matter, is reconciling market value and book value.)

What the Heck is Intrinsic Value?

Warren Buffett fans are familiar with the term intrinsic value. But what is it?

Book value is pretty easy to see. Current accounting standards are adequate for measuring buildings and equipment. But as society has become more complex, there are other ? less tangible ? factors that enter into a company?s value that don?t 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). With our modern market, it?s the intangibles in the form of patents, trademarks, research and development, brand, and so on ? that drives the expectations of future growth.

How it?s Calculated

Calculating intrinsic value can be messy. But like everything these days, you can find someone to do it for you. MorningStar calculates the number, which it calls ?fair value,? on its site; however, you need to be a member. Another good source is Reuters, which also requires a registration, but it?s free.

Value investing isn?t as sexy as some other styles of investing; it relies on a strict screening process. But just remember, there?s nothing boring about outperforming the S&P by 13% over a 40-year span.

Good Investing,

Jason Jenkins