The Art and the Science of Value Investing

This blog is the detailed study on value investing, it also covers all the different approaches of the same.

The plot

There are various approaches to invest your money in the stock market, and the one we are going to talk about have consistently made fortunes for those who have used it in the right way. Benjamin Graham who have developed the concept and also known as the father of value investing, Warren Buffet who is the 3rd richest person in the world and probably the most successful investor of all time, Peter Lynch, Rakesh Jhunjhunwala, Ramesh Damani, Ramdeo Agrawal all have used value investing and build their fortune, they also promote this approach as the way to financial freedom. Warren Buffet has famously quoted that “Investing is simple, but not easy” let us dive deeper into the world of investing and understand what is “value investing’ and how it works?

Before understanding value investing let us first understand the difference between price and value. Everyone understands what price is? “it is what we pay when we buy anything” simple! right. But the concept of value is a little complicated as “it is the real worth or usefulness of anything we buy” but it can differ from the actual market price, how? The price depends on demand and supply of a commodity and it keeps fluctuating, whereas the value remains the same. In a similar way, the share price of every company moves up and down every day but the value remains stable as it is dependent on the financial strength and future growth prospect and not on the demand-supply metric, we call it an intrinsic value of a stock. if the price is above the intrinsic value then it is “overvalued” stock and if the price is below than we call it “undervalued” company or it may be the same as the market price and we may call it “at par”.

What is value investing and how it works?

The concept of value investing teaches us to buy fundamentally strong companies which are currently cheap and in the long-run their share price will catch-up with the intrinsic value if the company is financially stable. Financial stability means a company should not have too much debt and must have positive cash flows, if cash is coming regularly in the business then it can carry out its daily operations. and later we can sell them when the price is high to book profit. A simple concept right! “Buy low, sell high” is a simple theory but it is not easy as the tools and techniques are complex and also require a good understanding of the business. There are techniques like DCF, Dividend discount model and growth model to arrive at the intrinsic value of a stock. Along with that, psychological aspects like discipline and patience are also important because we are talking about investments of ten years or more years. Let us break-down both the elements and look at them in detail.

DCF and the concept of free cash flow

Before starting, let’s get ready to chew some vegetables as in this section we will talk about all the complex but important concepts of value investing and understand the science behind it.

First let us understand the concept of Free Cash Flow, by the name only we can say that it is the money coming freely into the business after paying all the expenses and it is what the company gets. thus it becomes decisive to have healthy cash flows.

EBIT - It stands for earnings before interest and taxes, and it is the company’s earnings after paying all the expenses except interest and tax.

NOPAT - “net operating profit after tax” as we can see that we have subtracted tax from EBIT.

Depreciation: - A decrease in the value of an asset over time, it is subtracted during profit calculation, but we add it back because it is a non-cash expense and there is no outflow of cash.

Capital Expenditure: - Money required to expand the business must be kept aside that's why we subtract it from operating profit.

Working Capital: - Money required for continuous day-to-day operations is subtracted.

Discounted cash flow

In simple words, it represents the present value of all future cash flows also known as intrinsic value of a stock. and now you might be thinking how can we predict the future? Here the art comes into the picture, cash flows are driven by factors like revenue, cost, tax rates, investments etc. and require a very good understanding of the business to estimate what will the company get in future. So, it becomes subjective and depends on how optimistic you are about a company.

We take all the cash flows and discount them at their present value (NPV) but again, who decides that discount rate? Well it is decided by the cost of capital “Equity and Debt” and we take a weighted average to arrive at a percentage and thereafter we discount them, discounting is exactly opposite of compound interest calculation.

WACC - it stands for “Weighted average cost of capital” and used as the discount rate in the net present value calculation.

NPV - The net present value is the current value of all future cash inflows and it helps making the ultimate decision of whether to Buy, Sell or Hold by comparing it with the market value of a share.

Margin of safety

We all know that the future is unpredictable, and the art of valuation does not guarantee success also as humans we all make mistakes and to counter the potential loss, we must keep a margin of safety. It can be understood by an example of a juice shop, a shopkeeper who knows that the daily sugar requirement is 5 K.g. but he keeps 10 K.g. sugar in the stock to make sure he can cater the demand in case of requirement. Similarly, we must keep a margin of safety. For example, If Wipro’s current price is 355 and according to your valuation the price should be 380 then you should not jump into it just by seeing undervalued stock because there is always a margin of error in every calculation. and if your valuation is at 500 then the little margin of error can be ignored because, if it does not reach 500 then at least it must come up to 480. Also, the margin of safety depends on risk-bearing capacity and personal preferences of individuals; a 2/3 margin is considered as good by most of the investors.  

Brain Games

Now that we have finished our vegetables, here comes the brain games as you might be thinking that why everyone is not an intelligent investor and only buy companies which are "clearly" undervalued. We have compiled some psychological elements that come in the way of value investing.

Optimism: - Remember that we have talked about the importance of understanding a company and the business in detail. Understanding a business is itself a “Tight-rope walk” as the more you get involved with a company, the more you become optimistic about it. And thorough understanding of the business is also important therefore you need to become self-critique in order to get the correct valuation of the company.

Criteria: - Waiting for the company which satisfies your criteria is important because, you might not find one for a very long time, and all that you need to do is wait or change your criteria. Same as a tiger waiting for a fawn and jumps at the right time.

Nerve: - Now that you have bought the company and you see ups and downs in the market and inevitably you feel that your heartbeat is also synchronised with the share price of your company. well! in that case, you might get a heart attack, Yes! In the long run, the markets change as Bull and Bear faze come and go but you need to believe what you have bought is right and will reach where you expect it to reach.

Discipline: - An investor must be very clear inside his head that he purchases undervalued stock only because you might get along with market news and what others are buying and consequently end-up buying junk stocks. So if you have selected one or few stocks than you must stick with them.

Conclusion

You must have heard that investing in shares is equivalent to gambling, but value investing is not! although it does not guarantee success, it is a proven technique which is based on facts and calculations. First, you must know how to value a company, and then you can proceed, the only complexity is that it is highly subjective and requires a tough mind to execute. The calculation must be simple, and the numbers should carry a story to verify your estimates of cash flows as it will determine how much you value the company.

Points to remember

• Follow the right technique.
• Take time to estimate cash flows, and all the numbers must convey the answer to “why”.
• Avoid herd mentality and follow your estimates and judgement.
• Remember to keep a margin of safety.
• Avoid short-term movements, newspaper headlines and other market hypes.
• Be disciplined and have patience.
• And last – A good business will make money as share price will follow the real value, so make sure the business is profitable and you can see future growth.

“The secret to investing is to figure out the value of something – and then pay a lot less.” Joel Greenblatt