Stock Investing: A Guide to Value Investing

• One of the most revered and extensively followed approaches to stock selection, “value investing,” sprang to prominence when Benjamin Graham published “The Intelligent Investor.” Famous investor Warren Buffet has attributed much of his remarkable success to following Graham’s fundamental guidance in analyzing and picking companies for his portfolio. Buffet uses a combination of growth investing and value investing ideas.
• However, value investing has evolved with the markets during the last half-century. Investors and market analysts have made several modifications to Graham’s original value investing method over the years to boost the success rate of this investment style. Graham developed new valuation measurements and models to get closer to the stock price.
• Putting Value First
• To help you decide whether or not the current share price of a company represents a good “value” investment, we provide a variety of stock valuation methodologies and criteria to evaluate. It would help always to consider the industry and macroeconomic context when assessing a firm and its stock price.
• In addition, while analyzing stocks, it’s essential to constantly keep an eye on the future by looking at both historical and present financial data and forecasting how well you believe a firm will do in light of its current finances, assets, liabilities, market position, and growth plans.
• It’s also crucial to keep things in perspective and avoid getting too mired in the weeds of numerical analysis. Investors should not ignore non-monetary “value” considerations such as the efficiency with which a firm’s management accomplishes its objectives and advances the company in a manner consistent with its stated purpose. While current profits may be spectacular, in today’s too-competitive market, a business that isn’t meticulously charting its course and analyzing (and re-routing, if necessary) its development will almost certainly be overtaken by one that is.

Value Investing vs. Growth Investing

• It is vital to realize that “value investing” and “growth investing” are not two incompatible or mutually exclusive ways to choose companies before moving on to a study of classical value investing and then looking at some of the newer, alternative value investing techniques. Expected growth is central to value investing, which entails buying shares of companies that are now underpriced but that the investor believes will rise in price in the future.
• Strategies for value investing and growth investing differ primarily in their weighting of various financial indicators (and, to some extent, in their differences in risk tolerance, with growth investors typically willing to accept higher levels of risk). The ultimate aim of value investing, growth investing, or any other fundamental stock assessment strategy is to choose companies that will provide the highest rate of return.

The Basics of Traditional Value Investing

• Ben Graham has widely considered the pioneer of value investing. In “The Intelligent Investor,” Graham proposes and explains a stock-screening process he created to help even unskilled investors make better stock portfolio decisions. One of the main draws of Graham’s value investing strategy is that it is accessible to the typical investor since it is not unduly sophisticated or convoluted.
• Like any other investment strategy, Graham’s value investing technique is predicated on a set of fundamental principles. Graham placed a premium on the idea of a company’s or a stock’s intrinsic worth. The crux of value investing is spotting companies whose current share price is below their intrinsic value or worth via stock research and then purchasing those shares at a discount.
• Worthy investors use the same reasoning as frugal consumers to find companies that are “a good purchase” or trading at a discount to their intrinsic value. Then, assuming that the market will “correct” the share price to a higher level that reflects its actual worth, a “value investor” seeks and purchases equities they believe are undervalued.

Graham’s Basic Value Investing Approach

• investing results will improve if you partially adopt Graham’s value investing method in your portfolio selection process.Graham’s method for value investing focused on creating a straightforward procedure for stock screening that any investor could use. Overall, he kept things simple, but traditional value investing entails more than simply the oft-repeated “Buy companies with a price-to-book (P/B) ratio of less than 1.0.”
• In reality, Graham employed many factors to help him find inexpensive companies, the P/B ratio being only one of them. Graham developed a 10-point criteria checklist and advocated a more extended 17-point checklist; a distillation of either list appears in the form of a 4- or 5-point checklist, and Graham also advocated a couple of single criterion stock selection methods. Still, there is some debate among value investors as to which one is the correct one to use.
• To clear up any misunderstandings, we’ll lay out the major characteristics Graham himself regarded as most significant in selecting excellent value companies, i.e., those having an inherent worth greater than their market price.
• 1. The price-to-book ratio (P/B) should be 1.0 or below for a stock to be considered a value. The P/B ratio is helpful since it shows how the share price relates to the company’s assets. The P/B ratio works well when evaluating businesses with high capital requirements but has little use when applied to organizations with lower capital requirements.
• It’s important to remember that investors don’t necessarily need to seek firms with a P/B ratio below 1.0; instead, they may be content with finding those that have a P/B ratio that is below the average P/B ratio for companies in the same industry or market sector.
• 2. The stock’s P/E ratio should be at most 40% of its highest P/E in the last five years.
• 3. Seek a share price that is less than two-thirds (67%) of the tangible per-share book value AND less than two-thirds (67%) of the net current asset value of the firm (NCAV).
• It’s important to remember that the share price-to-NACV criteria are occasionally employed to find cheap companies. However, Graham believed that the NCAV was among the most reliable measures of a company’s intrinsic worth.
• 4) The sum of a company’s book value should be more than its entire debt.
• The primary debt ratio, often known as the current ratio, should be greater than 1.0 and ideally greater than 2.0 as another related or alternative financial statistic.
• It is recommended that a company’s overall debt not exceed two times its NCAV and that its current obligations and long-term debt not exceed its shareholder equity.
• Investors who are willing to explore Graham’s numerous criteria may establish which valuation measures or principles they find most necessary and dependable. Some investors still use a stock’s P/B ratio as the only criterion for determining its fair value. Others entirely or mainly base their decisions on how the current share price compares to the NCAV of the firm. Conservative investors may only purchase equities that meet all of Graham’s criteria.
• Your stock 

Alternative Methods of Determining Value

Graham’s value investing parameters are being studied by value investors today. As a result of the emergence of new vantage points from which to determine and evaluate the value, however, new approaches to finding companies that are now trading at discounts have also emerged.

The discounted cash flow (DCF) method is becoming more popular for determining value.

DCF and Reverse DCF Valuation

• DCF analysis has won over the hearts of many accountants and financial experts. For example, the time value of money, the idea that money accessible now is more valuable than the same amount of money available at some point in the future because it may be invested and utilized to produce more money—is one of the few financial indicators taken into consideration by DCF.
• The basic premise of discounted cash flow (DCF) analysis is that a company’s intrinsic value is highly dependent on its ability to generate cash flow, so it uses future free cash flow (FCF) projections and discount rates calculated using the Weighted Average Cost of Capital (WACC) to estimate the present value of a company.
• A DCF analysis boils down to the following calculation:
• Enterprise Value minus Debt Level Equals Fair Value.
• (Although market capitalization is often used, enterprise value is another relevant indicator. It is calculated as the sum of the company’s market value, debt, and preferred shares, less the company’s cash and cash equivalents.
• The stock is undervalued if the per-share value calculated by the DCF analysis exceeds the current share price.
• Given that DCF analysis’s fundamental shortcoming is its reliance on precise forecasts of future cash flows, it is best used for assessing businesses whose cash flows are steady and somewhat predictable.
• To reduce the risk associated with cash flow forecasting, some analysts favor using reverse DCF analysis. Using the current share price as a starting point, a reverse DCF analysis determines the cash flows needed to reach that price. Once the amount of cash flow needed to maintain or grow the current share price has been calculated, determining whether the stock is undervalued or overpriced is as easy as deciding whether or not it is fair to anticipate the firm being able to create that amount of cash flow.
• The stock is considered cheap when an expert concludes that a firm can create and maintain more than adequate cash flow to support the current share price.

A New Price-Earnings Ratio

Modeling using an Absolute P/E Ratio, as Proposed by Katsenelson

• Vitally Katsenelson devised a methodology for value investing that is especially useful for assessing firms with favorable, long-standing earnings scores; this model is called “Katsenelson’s model.” Katsenelson’s methodology is centered on giving investors a more trustworthy P/E ratio (called “absolute P/E”).
• Several factors, including earnings growth, dividend yield, and earnings predictability, are included in the model, which then modifies the conventional P/E ratio accordingly. Here is the formula:
• A company’s absolute PE is calculated as follows: Absolute PE = (Growth in Earnings Points + Dividend Points) x [1 + (1 – Business Risk)]. x = [1 + [(Financial Risk)-1] x = [1 + [Earnings Visibility]]
• Starting with a base P/E of 8 and increasing by.65 points for every 100 basis points in the predicted growth rate up to 16%, we can calculate the value of earnings growth points. For every 100 basis points of expected increase over 16%, an additional. Five percentage points are added.
• The two are compared to evaluate how the absolute P/E created stacks up against the conventional P/E. A company is cheap if its total P/E ratio is lower than the industry average. The more significant the difference between the absolute P/E and the average P/E, the higher the stock’s value. Suppose the absolute P/E of a stock is 20, but the standard P/E ratio is only 11. In that case, the actual intrinsic value of the stock is likely much higher than the current share price since the higher absolute P/E number indicates that investors are probably willing to pay a lot more for the company’s current earnings than the current share price.

The Ben Graham Number

• Establishing a new value investment yardstick is possible without abandoning Ben Graham’s methods. Graham developed the Ben Graham Number as a supplementary tool for investors to determine intrinsic value.
• A simple formula may be used to get the Ben Graham number:
• In finance, the Ben Graham Number is calculated as the square root of (22.5) times (EPS times) (book value per share).
• If a company has an EPS of $1.50 and a book value of $10 per share, its Ben Graham number is $18.37.
• According to Graham, a company’s price-to-earnings (P/E) ratio shouldn’t be more than 15, and its price-to-book (P/B) ratio shouldn’t be more than 1.5. This is where the formula gets its value of 22.5 from (15 x 1.5 = 22.5). Current valuation levels suggest that the upper limit on P/E might be lowered to the mid-20s.
• You may evaluate whether or not you are getting a good deal on a stock by comparing the Ben Graham Number you’ve generated (which is meant to reflect the stock’s actual per-share intrinsic value) with the current share price.
• For a stock to be undervalued, its current share price must be less than the Ben Graham number before it can be deemed a purchase.
• If the stock’s current price exceeds the Ben Graham Number, it is expensive and probably not a good investment.

The Bottom Line

Value investors always look for inexpensive stock bargains to maximize returns while minimizing risk. A stock’s genuine worth and suitability for an investor’s portfolio may be assessed using several methods and techniques.

The ideal stock valuation technique is never as simple as plugging numbers into a formula to determine if a stock is a “good” or “poor” investment. Even though there are essential stock valuation formulas and financial metrics to think about, evaluating a stock as a potential addition to your investment portfolio is ultimately part art, part science, and partly a skill that can only be mastered through time and practice.