How to Really Start Value Investing

»Alternatively, you can also download this guide as a PDF.

Value investing is a fundamental investment approach that implies buying stocks at a discount of their intrinsic value. 

Throughout the time, value investing has gotten more and more attention as many legendary investors such as Warren Buffett, Charlie Munger, and Peter Lynch have shown that most people can achieve great success with investing and that it doesn’t have to be as complicated as rocket science. 

You might have gotten somewhat interested in value investing. Maybe because you’ve heard of Warren Buffett and his success, and you want to learn how he invests and thinks about stocks. 

Great! But where and how exactly should you start? This guide is going to walk you briefly through the core and basics of value investing and then show you some suggestions on how to getting started with value investing.

What is Value Investing?

Within the investment world, many people view value investing as a counterpart to growth investing, which is another major investment style. Investors seem to constantly try to debate with each other about which investment approach stands out to be the superior one, by classifying both investing schools with certain characteristics and measuring the performance of each one. 

But true value investing isn’t just some sort of strategy that everyone can apply immediately by implementing some financial ratios and metrics. It is much more than that. It’s a certain way of thinking about concepts and occurrences that are happening within the finance world. 

Understanding how value investors invest isn’t too difficult because it doesn’t demand a lot of complicated theories that are being taught in academics. All that value investing requires is a genuine interest and open-mindedness in the topic paired with a healthy amount of common sense. 

Let’s start with the fundamentals of value investing.

Understanding the Fundamentals of Value Investing

Invest in Businesses, Not Stocks

The first thing to understand is the fact that when you buy a stock, you simply just don’t buy a ticker symbol attached with a price tag that will hopefully go up sometime in the future. What you’re actually buying is a share of a business. You acquire ownership out of a company and with each share you buy, your ownership becomes bigger and bigger.

After acquiring a stock, you essentially become a shareholder and part-owner of that publicly-traded company.

You probably know that already but being an owner of a business also implies thinking like an owner.

For instance, let’s assume that a friend came to your house to offer you a part of his business for a considerable amount of money.

Let’s say you have the money to say yes to the offer. Of course, you would ask him some questions about the business first before actually considering buying into the company. What would you ask him?

Some good questions that you might find could be: What kind of products or services does the business produce? How does the business make money? Who manages the business? Does the business have a long history, or has it just come out recently? How large is the business? In what industry does the business operate?

Such questions may seem obvious at first but they would give you a much better view of the business and would also help you make the right choice before deciding to have your money on the line right? I mean, who would blindly buy a company without even knowing a thing about the business itself right?

The truth is that many investors, especially people who’ve just started, behave exactly like that within the stock market. They either think that investing in the stock market will provide them with incredible returns, or that stocks are some sort of risky assets that can lose them quite a lot of money at any given time.

Then there are investors who just buy a certain stock because someone closely recommended it to them, or as they watch people constantly talking about how good the company is, or because they constantly see the price of the stock going up, arriving at the short conclusion that it will continue to do so.

But value investors think and act in a completely different way. They know that stocks are shares of real companies and that a lot of time should be spent on knowing and understanding any investments before arriving any further conclusions. 

Understand the Businesses That You Own 

So before you make any stock-picking decisions, understand that you’re about to become an owner of a business, meaning that you should also think like an owner. Try to get a deep understanding of the business that you’re about to buy.

Start at getting familiar with its financial health, product line, future outlook, history, business model, management, operating industry, and so on.

And as you read and learn all these things about the company, ask yourself this question: What exactly do I like about the business? Why do I think could this company be a good investment for me?

Set yourself some requirements and standards which every business needs to have to be on your investment portfolio. Good examples of standards could be: “I’m only willing to invest in businesses that have existed for at least 10 years” or “I only invest in companies that have products, which I would use for myself”, or “I only invest in firms that are led by trustworthy and wise people”.

Realize that there are hundreds of thousands of publicly traded companies worldwide and thousands of businesses trading on the U.S market alone. You will most likely never run out of options so you shouldn’t worry too much about any opportunities that you might miss by setting some requirements for the companies that you would like to own. 

The Difference Between Price and Value

Have you ever seen a stock that was first trading at a certain price level and then suddenly doubling in the following day? This isn’t too much of a rarity within the stock market. You will regularly hear about stocks that go up 60% 80% or 120% within a few days or weeks.

One question that you might ask yourself is: How can stocks move up (or down) to such a huge extend within such short time periods? Does this mean that the underlying business has grown so rapidly?

The answer is in most cases no. That’s because stock prices don’t necessarily reflect the true value that you are really getting out of a business.

In order to realize that there is a difference between price and value, it’s important to understand that stock prices are completely defined by the demand of investors. If people are suddenly willing to buy and sell a stock at the $300 mark, then that will be the stock price for the given company.

Let’s assume that you’re about to go to your local supermarket to buy some toilet paper. If at the supermarket, you see the only package of toilet paper left, priced at $50, would you be willing to buy it for such an insane price tag?

Probably not, because you know what toilet paper is normally worth and the true price point is usually much lower than $50 isn’t? As a result, it can be said that there is a clear distinction between the value for each toilet paper roll and the price that you pay for it.

In this example, you might ask yourself how toilet paper can even be priced so high. It’s just soft paper, right? How would anyone be willing to buy paper rolls for that much? The truth is that so many investors are doing exactly that when it comes to investing in stocks.

In fact, many investors don’t even care about the price of a stock and how it relates to its underlying value. They just decide to buy it when they assume that the company is going to do well in the future.

Within the stock market, there can only be undervalued or overvalued stocks, if there is a difference between price and value. If every single stock price of all publicly trading companies would reflect the underlying value behind the stock, value investors wouldn’t be able to buy stocks at a discount and aim for market-beating returns in the first place.

So as soon as you understand and realize that there is a clear distinction between a stock’s price and value and that the market will occasionally offer opportunities where you can buy companies that trade below their intrinsic value, then you’ve pretty much understood the core of value investing. 

Every Investment Has a Value

So how exactly can you find the underlying value of each stock? After all, the only number that everyone can see is a stock’s price tag, right? This is where value investing gets tricky.

As a value investor, you would need to define and estimate the intrinsic value of each business for your own. There is no official source that can tell you the intrinsic value of a stock with a hundred percent guarantee. Each individual investor has their own estimate of intrinsic value for a stock, and there are several different valuation approaches to define that number. 

In general, there are two types of valuation. Those are called relative valuation and absolute valuation. 

• Relative valuation refers to comparing businesses with other similar companies or benchmarks, using valuation metrics such as the P/E ratio, PEG ratio, P/FCF ratio, or the EV/EBITDA ratio. 

• Absolute valuation, on the other hand, is used to calculate a certain number (intrinsic value), by estimating the future income streams of a business and coming up with a figure that you would pay for those income streams today. 

»Learn more about the price-to-earnings ratio

Generally, relative valuation is much easier to understand and utilize, while absolute valuation will give you the benefit of handing you a real number that you can hold on to make up investment decisions.

That being said, the key thing to understand here is that each stock has an underlying value that can always differ from its current stock price. And one of the main challenges for a value investor is to determine that intrinsic value to further decide if the stock would be a good investment at the current price.

Think in the Long-Term

The stock market can be extremely volatile in the short-term, meaning that stock prices can fluctuate heavily both to the up and downside.

Value investors mostly do not care about any price fluctuations in the short term. Trying to have consistent success in the short run is meaningless and rather depends on luck than common sense and skill.

The best investors in the world have made their fortunes by focusing on buying companies that can be held in the long term. People who try to make a quick buck in the stock market are rather speculating instead of investing because everything can happen in the short-term. It is thus nearly impossible to accurately predict any outcomes in the short-term.

Therefore, you should ignore most of the news you hear regarding your investments as long as you fundamentally still believe in the company. Try to evaluate if any short-term incident really changes the fundamental value of your investment or just happens to be a temporary problem that other people are overreacting at. 

How to Start Value Investing

Be curious and passionate

If you’ve come this far reading to this point, great! Nevertheless, I would ask you to sit back and take a minute to ask yourself one question. Why are you reading this article? Why did you even start learning about value investing in the first place?

This is an important question and chances are that you wanted to be actively involved in stocks simply because it’s interesting, or because you have a lot of fun while doing it. 

Of course, the primary incentive for us to actively invest instead of passive investing is to achieve above-average returns. It doesn’t make a lot of sense if you would only make 4% each year with the stocks that you have picked, while the average market makes 8% per year.

The reason why I’m coming up with this point is that if you’re just obsessed with making superior returns than the average market, but you’re not having fun while doing it, I wouldn’t recommend you to start value investing. 

The truth is that value investing requires a good amount of interest, curiosity, and passion in the long run. So please be clear about what you really want. 

If you are not passionate about the things that you do, chances are that you are not going to have success with them. This may sound like a very general life advice but it also applies to investing. 

So if you just want to have good returns then go ahead and invest in an index. You will make good returns and your wealth is going to compound over time as long as you keep a long-term mindset.

Great Sources to Start From

Choosing an Investor to Learn From

Learning from the history of successful investors instead of trying to figure it out on your own will not only save you massive time, frustration and losses but also help you start with the right mindset and guidance in your journey.

Warren Buffett isn’t the only value investor that you can learn from. There are many other incredibly successful value investors that provide lots of insights and information on how they invest. While all value investors follow the same fundamental principles of value investing, each investor will have his own personal style of investing.

Therefore, it’s important for you to choose how your own style of investing is going to be.

But you may ask how to learn from the best investors? There are often biographies about them in addition to books and memos that they have written. You might also find many interviews that they’ve given. Study their philosophy and investment style, and ask yourself: Which part of investing do they personally emphasize on? How exactly did they achieve their success?

Peter Lynch, for example, has written multiple books such as “One Up on Wall Street” or “Beating the Street” that are relatively easy to read for beginners.

His investment style especially emphasizes on thoroughly understanding the stocks which you own and that it’s more about the psychological mindset instead of pure brainpower that leads to successful investing.

»Learn more about other legendary value investors

Value Investing Books

Additionally, there are also lots of books all around value investing written by many successful and wise value investors. Here are some of the books that I recommend for starters.

• The Intelligent Investor by Benjamin Graham
• Beating the Street by Peter Lynch
• The Most Important Thing by Howard Marks
• The Little Book That Still Beats the Market by Joel Greenblatt

Berkshire Hathaway’s Shareholder Letters

Another great source where many investors choose to start from are Warren Buffett’s letters to shareholders.

Every year, Warren Buffett writes a letter to the shareholders of Berkshire Hathaway. Those letters are widely considered as some of the best lessons that all investors (especially value investors) can learn from. 

I mean, who wouldn’t consider taking lessons from arguably the most successful investor of all time for completely free? 

Here is a link to Berkshire Hathaway’s site that contains all shareholder letters downloadable from 1977 up to the most recent ones.  

Getting Started: Absorbing as Much Information as You Possibly Can

Let’s get a little practical. As soon as you got familiar with the basics, try to choose the first business that you will start analyzing. When you found a company that you are interested in, which might have the potential to be a good investment, it’s time to do your homework.

Learn how to read the three primary financial statements (income statement, balance sheet, cash flow statement). Every publicly-traded company in the U.S. is required to provide those statements to the public.

Then, start analyzing the financial statements of your company. Those will give you a good amount of insights around the financial position of the business. 

After that, start reading the annual reports (10-K) of the business. Within those reports, you will find plenty of information about the company that you will need to further determine if the company is a good investment or not. 

Try to grasp information about the industry in which the business operates including its competitors. Get familiar with the company’s products, risks, business segments, management, future prospects, and so forth. 

Come to a conclusion. Do you think that you’re dealing with a great company that you can really invest in? Great, now it’s time for valuation. Learn and choose an approach that you will use for the company to come up with a price that you would pay for it right now. 

A common way to define your intrinsic value is the discounted cash flow (DCF). Figure out how much your business can grow its cash flows in the future and discount them with your required rate of return back to the present. You should now have an estimate of the stock’s worth. Is the current stock price below or above your intrinsic value? How big is the margin of safety? 

All these steps might seem quite overwhelming to you to begin with. It definitely takes days, sometimes weeks to go through all the steps of analyzing a business. Just try to take one small step at a time and after a while, I can assure you that all these things will become easier for you, depending on the amount of time and effort that you put into your skills.

But in the end, learning is a never-ending process. The steps above are just an example that roughly outlines the approach that I personally use to learn more about the businesses that I’m analyzing. In the end, it’s completely up to you to define your own individual value investing way.