Value investing is an investing style where investors scout for stocks that are undervalued compared to the current market price (CMP). Value investors compare the intrinsic value of the stock to its market price at which it is trading on the exchanges. 

If the current market price of the stock is more than the intrinsic value of the stock, then the stock is overvalued. In contrast, if the CMP is less than the intrinsic value of the stock, then it is undervalued. Value investors are long-term investors and they do not believe in the efficient market hypothesis or theory. 

What is an Efficient Market Hypothesis?

Efficient market hypothesis is a theory where investors believe that the current market price of stock is the real value because the market participants have already priced in all the information known to them.

The hypothesis states that the CMP reflects all past data like historical prices, trading volumes, publicly available information like published news, financial statements, and economic reports. Therefore, the CMP always reflects the true value of the stock. 

However, value investors reject this hypothesis and they believe stocks are mispriced most of the time because the stock market always goes through cycles and there is always an opportunity for investors to find stocks that are undervalued. 

What is Intrinsic Value?

Intrinsic value is the real value of the underlying asset based on the fundamentals of the company. So as an investor, if you want to find the intrinsic value of a stock, you must know fundamental analysis which involves knowing to read and interpreting balance sheet, profit and loss numbers, cash flow statements, annual reports, business models, etc. 

Some of the important metrics that value investors must know are as follows,

Price-to-Earnings ratio: This ratio is one of the most commonly used and popular ratios to roughly value if the stock is overpriced or not. This ratio compares the price of a share to the earnings per share. It shows how much investors are willing to pay for every unit of earnings made by the company. If the PE ratio is low then the stock is undervalued and if it is high then it is overpriced but the market expects there is very high potential for growth.  The PE ratio should not be seen in isolation and it must be compared with industry average or the company’s average PE. 

Price-to-Book ratio: It calculates the price of the share to its book value. The book value is nothing but the net asset which is calculated by total assets minus total liabilities of the company. The ratio is useful for banks, NBFCs, manufacturing companies and other asset heavy companies. If the PB ratio is less than 1, then the company is undervalued and if it is higher than one then the company’s stock is overvalued or the market is expecting higher growth in the future. 

Return on Equity:  The ratio is used to calculate how the company uses shareholders’ capital efficiently to generate profits. If the company has a consistent high ROE, it means that the company has good capital management and efficiency. For value investors who are also long-term investors, this is important because a stable and strong ROE will have a positive impact on the intrinsic value. 

Free Cash Flow (FCF): It is one of the important metrics to gauge the intrinsic value of a company’s stock. Even though a company is able to generate net profits, it is crucial for a company to have a positive free cash flow so that the company can expand its operations, reduce its debt, pay dividends to its shareholders, invest in R&D, etc. Free cash flow is the cash that is remaining after operating expenses and capital expenditures like buying large equipment, land, manufacturing plants, etc. or upgrading machines. 

Debt-to-Equity ratio: This ratio is helpful for value investors because it shows how much debt a company has taken with respect to shareholder’s equity. It is helpful in assessing the financial risk of the company because value investors like to invest  in companies which have low or no debt. Companies with excessive debt are dangerous for value investors because if the company is unable to pay off its debt, the debt will compound and it will have an adverse effect on the intrinsic value. 

Margin of safety

For value investors, margin of safety is really important because this metric protects investors from losing their investment capital or any downside risk. In simple terms, it is the buffer between the intrinsic value and the current market price of the stock. If the CMP is really less than the intrinsic value, then you have a high margin of safety and you are getting the stock at a good bargain. In contrast, if the margin of safety is low then there is little room for error and it is riskier in terms of investment. The formula is as follows,

Margin of safety = (1- (CMP/Intrinsic Value)) * 100

Conclusion

As Warren Buffet has said, price is what you pay and value is what you get. Value investing is the core of investing and it is an investment philosophy that is rooted in long-term outlook, patience and discipline. As a value investor, you must know the fact that you cannot pay any price for the share of a good performing company. If you are a value investor, you do not have to speculate and be a part of the herd. I would like to end with Buffett’s words: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”