Investment gurus often talk about value investing. What is value investing and is it a profitable approach to building your retirement nest egg or simply getting rich? Here is what Investopedia says about value investing.
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[Value investing is t]he strategy of selecting stocks that trade for less than their intrinsic values. Value investors actively seek stocks of companies that they believe the market has undervalued. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with the company’s long-term fundamentals. The result is an opportunity for value investors to profit by buying when the price is deflated.
Typically, value investors select stocks with lower-than-average price-to-book or price-to-earnings ratios and/or high dividend yields.
A simple approach to value investing is to use a stock screening tool like the one in Google Finance to find stocks with low price to earnings ratios (P/E ratio) or price to book ratios and high dividends. However, finding a list of such stocks is only the beginning.
How Does the Company Make Its Money?
The famous investor Warren Buffett says that he only invests in a stock when he has a clear idea of how the company makes its money how it will continue to do so for the indefinite future. Buffett invests in blue chip companies such as Wells Fargo & Co, Coca Cola Co, Kraft Heinz Co, American Express Co and U.S. Bancorp. These are his biggest holdings. Buffett is considered the most successful investor in history and is the third richest man in the world. Business Insider notes that if you had invested $1000 in his company, Berkshire Hathaway, when he took it over in 1964 your shares would be worth about $11.6 million today. That is a ten thousand fold return on investment with the guru of value investing.
Using historical price data for Berkshire Hathaway class A shares from a retrospective analysis of Buffett’s outsized returns and from Yahoo! Finance, we calculated how much $1,000 of Berkshire stock would be worth today if you invested that money at different times during Buffett’s tenure.
That $1,000 invested in 1964, when Buffett took over the company and shares cost just $19, would be worth about $11.6 million dollars today, based on the last available closing price of $221,180 on February 27. $1,000 invested in 1990 would be worth $33,136 today.
The belief of a value investor is that it is very tricky to try to repeatedly anticipate the market and thus these folks avoid day trading and swing trading. Rather they look at the intrinsic value of a stock and buy when the market is underpricing the stock and sell when the stock is overpriced.
Think of intrinsic stock value as the fundamental value of the stock. Analyze the stock to determine its price based on predicted future income and then subtract the current stock price. Calculate expected company cash flow and then discount to current dollars. Determining intrinsic value of stock is a discounted cash flow valuation. The key to determining intrinsic value of stock is getting a clear idea of the medium and long term prospects of the business in question. Successful stock investors learn to judge how well a company will manage its assets, products, costs, R&D, and marketing. When the picture is clear an investor can make an informed decision. If the market price is less than the intrinsic value of stock it is time to buy and if one owns the stock and the prices are reversed it is time to sell.
Successful value investors never guess and when they receive a stock tip they investigate it thoroughly before risking their money. After all Buffett says that the first rule of investing is not to lose money and the second rule is to remember the first rule!