Definition: Value investing is an investment philosophy that focuses on the fundamentals of a company in an effort to pick stocks that are trading for less than inherent value. In other words, itís a strategy of looking at characteristics of a company like cash flow, operational efficiency, and market competition rather than looking at its current market price and market history.
This strategy began primarily with Benjamin Graham, a professor and professional investor in the early 20th century. He created a thorough guide that focused on the companyís cash flows, ability to pay debt, future prospects, and other factors in order to arrive at a valuation of the company.
The idea is that the market might either misunderstand a company or undervalue its true earning potential. By looking at the business fundamentals, a savvy investor can estimate what a company is actually worth regardless of where the market sets its price. Once you find a company that is being undervalued based on its operations, you can invest at the low market price. When the market figures out how much it is actually worth, the stock price will increase.
Furthermore, value investing is usually conducted with a discounted cash flow analysis, that attempts to value the present value of all future cash flows of a business, based on a variety of operating and efficiency factors. It is heavily based on oneís view and assumptions about the company and is used today by a host of successful hedge funds, institutions, banks, and individual investors.
Letís look at an example.
Bob wants to invest in the stock market. He has $10,000 to invest and believes that the retail sector is best. The only company that interests him in that sector is Retailís, because he loves their clothes and shops there almost every day. However, the stock is trading at $40, and he believes that might be a little expensive.
In order to validate his intuition, he begins to take a look at the companyís public financial statements: SEC Filings such as its annual report, quarterly report, proxy statements, and other documents in order to get more familiar with the business. In particular, he focuses on managementís discussion of the future and its plans, and compares that with past plans to see if the company follows through.
He finds that management is very reliable in terms of delivering on their projections, and they have multiple store openings and new exciting products to be launched. Additionally, the firmís revenue has increased 15% year over year, with a 30% increase in net profit and 10% decrease in operating costs. So far, Bob decides he likes what he sees, and now takes a look at the firmís credit rating.
Fortunately, it is AAA, the highest rating for a corporate company, which means they have always paid their debts on time and in full. He decides to create a discounted cash flow analysis, and he values future cash flows at $65. He remembers the stock was trading for $40, and decides to apply a margin of safety of 15%: (65 / 40-1) x 100 = 62.5%. That is well within his margin of safety, and he decides to purchase $10,000 shares of Retailís stock, which comes out to 250 shares.
Investing based on the fundamentals of a company is oftentimes fortunate, as value investors hope that the market will realize the companyís impressive performance with an increase in share price.
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