If you’re looking for a way to invest your money and beat the market, you may want to consider value investing. Value investing is a style of investing that involves buying undervalued stocks that have strong fundamentals and growth potential.
Value investing was popularized by Benjamin Graham, the father of value investing and the mentor of Warren Buffett, one of the most successful investors of all time. Graham defined value investing as “the art of buying securities which are being sold at a significant discount to their intrinsic value”.
Intrinsic value is the true worth of a company based on its assets, earnings, dividends, cash flow, and growth prospects. The intrinsic value of a company may differ from its market price, which is determined by supply and demand and influenced by emotions, expectations, and speculation.
Value investors aim to find stocks that are trading below their intrinsic value and buy them at a bargain price. They believe that the market will eventually recognize the true value of these stocks and reward them with higher prices. Value investors also tend to hold their stocks for a long time, ignoring short-term fluctuations and focusing on long-term performance.
Value investing has many benefits, such as:
- You can achieve higher returns than the market average. Value stocks tend to outperform growth stocks and the market in general over the long run. According to a study by Fama and French, value stocks had an average annual return of 12.9% from 1927 to 2019, compared to 9.7% for growth stocks and 10.2% for the market.
- You can reduce your risk and volatility. Value stocks tend to be less risky and volatile than growth stocks and the market in general. This is because value stocks have lower price-to-earnings (P/E) ratios, lower price-to-book (P/B) ratios, higher dividend yields, and higher margins of safety than growth stocks. These factors indicate that value stocks are more stable, profitable, and resilient than growth stocks.
- You can benefit from compounding. Value investing is a long-term strategy that involves reinvesting your dividends and capital gains into more value stocks. This way, you can benefit from compounding, which is the process of earning interest on your interest. Compounding can make your money grow exponentially over time. For example, if you invest $10,000 in value stocks that pay 4% dividends and appreciate 8% per year, you’ll have about $108,000 after 20 years. But if you invest the same amount in growth stocks that pay no dividends and appreciate 10% per year, you’ll only have about $67,000 after 20 years.
So how do you start value investing and find undervalued stocks? Here are some steps to follow:
- Do your research. The first step to value investing is to do your homework and analyze the financial statements and performance of various companies. You should look for companies that have strong fundamentals, such as high earnings, low debt, consistent cash flow, competitive advantage, loyal customer base, etc. You should also look for companies that have strong growth potential, such as expanding markets, new products or services, innovation, etc.
- Calculate the intrinsic value. The next step is to estimate the intrinsic value of each company based on its fundamentals and growth prospects. There are different methods to calculate the intrinsic value of a company, such as discounted cash flow (DCF), dividend discount model (DDM), earnings power value (EPV), etc. You should use the method that best suits your preferences and assumptions.
- Compare the intrinsic value with the market price. The final step is to compare the intrinsic value of each company with its current market price. You should look for companies that are trading below their intrinsic value by a significant margin. This margin is called the margin of safety, which is the difference between the intrinsic value and the market price expressed as a percentage of the intrinsic value. The higher the margin of safety, the lower the risk and the higher the potential return. A good rule of thumb is to look for companies that have a margin of safety of at least 50%.
By following these steps, you can find undervalued stocks that can offer you high returns with low risk over time. Remember that value investing is not a get-rich-quick scheme but a disciplined and rational approach to investing. It requires patience and perseverance to stick to your strategy and ignore market noise. But with a little planning and effort, you can become a successful value investor.