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Value investing: It’s not as difficult as you think

What is value investing?

There is nothing better than Charlie Munger’s quote to start a topic on value investing.

All intelligent investing is value investing—gaining more than you are paying for. You must value the business in order to value the stock.
— Charlie Munger

Likewise, Charlie Munger,  the other well-known value investors like Warren Buffett and Peter Lynch also believes the same that value investing is an intelligent way to do investing.

Above all, value investing requires the control of sentiments and using the skill which is a combination of art and science to analyze the company for the high return from the market.

One of the fundamental ideas behind value investing is to look over the company performance, not on the market performance, which avoids the stress on the value investor during the volatile market.

Value Investor vs common investor

The common investor knows the principles of value investing very well but he cannot get returns because he/she always tries to:-

  • Predict the market
  • Get the maximum return in a short time
  • Become a part of the crowd to avoid the risk

whereas,

Value investors like Warren Buffett research well based on his investment style and invest in a company for a longer time. For instance, Warren Buffett bought coca-cola, wells Fargo and American express stocks in the early days of his career and continues to stick with them for over 30 years. 

Value investing vs growth Investing

As the name suggests, growth investing is an investment in stocks with the potential of high growth at a reasonable price in near future, whereas value investing is an investment in stocks with the potential of high return in the long term.                  

Growth investing considers the stocks with the quality of the earnings and it grows higher than the industry and market index with the high P/e. For example Eicher Motors, MRF Tyres.

On the other side, value investing considers the stocks whose growth rate may be slow, but their actual value is higher than the current market price. For example IOCL, HDFC, Infosys.

Definitely, growth investing is popular and gives good returns in a shorter span, but in the long run, the results from value investing are unbelievable.

Generally, growth stocks have high P/E and value stocks have a low P/E ratio

To summarize, the growth stocks rise fast but they may not sustain for a long time, whereas the value stocks require time to show their potential but once admire by investors can cause unbelievable returns.

6 criteria to identify the value stocks

Value investing is a combination of art and science to find the value stocks from many stocks in the market.

However, science can be defined but the art to use it require person-to-person capability.

The major task of a value investor is to find undervalued stocks.

The 6 criteria to identify the value stocks are:-

  1. The current stock price should be lesser than its intrinsic value
  2. The business model should be simple to understand
  3. The company’s product can sustain in the long-term economic characteristics.
  4. Lead and managed by honest and capable leaders
  5. Low debt over the company
  6. High return on equity

It is possible that some quality businesses are loaded with high debt because of their nature of the business, but if the business nature does not demand the high debt and it loads company with high debt, then it is a red alert

3 important financial ratios to find the value stocks

Financial ratios play an important role to find the undervalued business and help the value investor to invest in the right business.

The 3 important financial ratios to find the value stocks are:-

  • Price to Earnings ratio
  • Price to Book value ratio
  • Debt to equity ratio

1. Price to Earnings ratio –

Price to earnings ratio (P/e) plays an important role in finding the valuation of the company.

It is the ratio of the current market price of a company’s share to its earnings per share.

{\displaystyle P/E={\frac {\text{Share Price}}{\text{Earnings per Share}}}}

It is the easy and fastest way to find whether the company is undervalued or overvalued compared to competitor, Industry segment, and historical P/e ratio.

2. Price to Book Value ratio –

It is a ratio to compare the current market price of a company’s share to its book value.

Book value represents the current asset value of a company on the books. Hence, the P/B ratio helps an investor to check the valuation of a company.  

3. Debt to equity ratio

It is the ratio to compare the company’s total liabilities with the shareholder’s equity. Higher the value of the D/E, riskier to invest in the company.

However, some businesses demand high debt to operate their businesses.

When to re-analyze the business?

It is always advisable to keep a track of the business if you observe that:-

  • The company’s management vision is shifted
  • The current stock price becomes higher than its intrinsic value
  • The company’s product will not suffice the demand of the consumers.

Then, it is the right time to re-analyze the business and exit, if it doesn’t look attractive.

Don’t follow the crowd, follow Benjamin Graham

It is difficult to stick to the market when everyone is moving out of the market because of the influence of short-term bad news.

But the bad news cannot sustain for a long time and people will appreciate your research and make your stock most popular.

Always remember the quote of Benjamin Graham “In the short run, a market is a voting machine but in the long run, it is a weighing machine.

Four Pillar of value Investing is not for everyone

It is clear that value investing is highly profitable, but it does not suit everyone. It is important to follow the four pillars of value investing to get maximum results. These four Pillars comprise:-

  • Patience
  • Discipline
  • Intense Research
  • Controlled sentiments

Conclusion

Value investing looks simple but not meant for everyone, it requires ingredients that may not be a strength for everyone. 

An investor should choose the investing style such as growth investing, trading, or value investing only based on their strengths to get the best results.

It is important to remember Peter Lynch’s famous quote i.e.

“The person who turns over the most rocks wins the game.”

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