Let’s suppose that you are about to enter the biggest electronics store in your local area. Suddenly, you notice an eye-catching sign in front of the entrance, saying “All Electronics 50% off! Only for a limited time!”.
How would you react to such an offer, especially when you already wanted to buy a new TV in the first place? Most people would probably at least consider buying items at such a discount. This would only make sense, as you would pay for something at a substantial premium when it’s normally worth much more.
So if most people wouldn’t hesitate on taking advantage of such a discount, and many people even actively look for discounted prices in almost any possible area of their lives, you may not be surprised of the fact that it is no different for many investors when it comes to investing in the stock market.
- Stocks can certainly be bought at a discount of what they’re really worth at the stock market. Stocks aren’t just ticker symbols and price figures but represent real businesses that sometimes operate better than what they’re really worth and vice versa.
Investors who actively look for businesses that are priced at a discount of their worth are called value investors and one of the most successful investors that you may have already heard of is Warren Buffett. He is arguably considered the most famous and well-known value investor.
Investing in the stock market can definitely be compared with the real-life example mentioned above. When you look for stocks to invest in, it is like going through the mall and choosing the right item that is suitable for your needs.
The price tag of each product at the mall reflects the current trading price of a stock. At the stock market, prices can fluctuate much heavier than the price tags at your local supermarket.
However, sometimes prices will fall into an attractive price point, just like the products at the shelf of the store can sometimes be offered at a discount.
As soon as you see a product offered at a discount you naturally become encouraged to buy it since your brain automatically wants to make use of the current situation.
Value investors essentially try to do the same when buying stocks. They know how to differentiate between the current market price and the real value of the underlying business. When the market suddenly offers one of their favorite stocks at a price, which is below its real value, they certainly consider buying it.
The Difference Between Price and Value
“Price is what you pay, value is what you get”
Of course, there are some difficulties involving value investing and simply buying stocks at a discount. The comparison between shopping in the mall and value investing is just to show that the essence of this investment philosophy is no different than the example.
Value investors believe that there is a clear difference between the stock price and its underlying value. Determining that difference is one of the main challenges that need to be faced in the first place.
Not everyone thinks that there is a clear difference between the price and value of a stock. Many investors believe that markets have become efficient and that the current stock price always reflects the value of the underlying business.
That being said, differentiating between price and value is a well-known principle that has historically brought many investors incredible returns and it’s also what made Investors like Warren Buffett achieve their investing success that they have today.
The main problem that investors encounter when trying to buy stocks at a discount is simply the fact that you can’t actually look up the true value of a stock. The only price that everyone sees is the current market price. So, in the end, it is completely up to you what the real value of a stock is.
The Margin of Safety
“The three most import words in investing… Margin of Safety”
Buying stocks at a discount essentially means buying stocks at a market price, which is lower than its true value. The bigger the spread between price and value, the greater the discount. Value investors also call the difference between the current stock price and the intrinsic value margin of safety.
As its name suggests, the margin of safety can be described just as a safety net, which both reduces the downside risk of an investment and provides substantial upside potential.
Therefore, applying a margin of safety with each investment you make, can be a very important step to your investing success.
»Learn more about how to use the margin of safety
How to Determine the Value of a Stock
One way to assess the value of a stock is to first analyze the financial numbers of the business that you may want to invest in and put it into comparison with the price that you have to pay for the stock. Moreover, you then can compare those value metrics with the metrics of other businesses to find out, which one has ‘more value’ for the buck.
Probably the most common valuation metric that investors use is the price-to-earnings ratio (P/E). It essentially shows how much money you are paying for the earnings of a business. For instance, if a stock has a P/E ratio of 15, it would mean that you pay 15 times the earnings of a stock (EPS) as the current stock price. In simpler terms, at a P/E of 15, you would pay 15 dollars for each dollar of earnings of the business.
As a result, it would be logical to say, the lower the P/E ratio, the more earnings you are getting for your money. However, if a stock with a P/E ratio of 5 really makes a better investment than a stock trading at a P/E of 20, can’t be really determined by just looking at the price-to-earnings level. There are many more factors to take into account when answering such a question.
That being said, one of the reasons why the price-to-earnings metric is so commonly-used is the simplicity and easiness to quickly get a glance company’s value. And because the P/E ratio directly reflects the relation between price and earnings, it is also often associated with value investing in general. This is why sometimes you may hear investors defining value stocks as stocks that are only trading at a P/E below 15.
In addition to the P/E, there are some other financial metrics that indicate the value of a business. Typical value metrics include:
- Price-to-book ratio. Similarly to the P/E multiple, the price-to-book ratio can be calculated by dividing the current stock price with the book value per share.
The book value is the per-share amount of shareholder equity for the business. Just like the price-to-earnings, a low P/B ratio would tell that you are getting more equity per share for the price that you need to pay for the stock.
Equity plays an important role within the business, as it essentially represents the amount of money, which would be returned to the investors if all assets were liquidated and debt obligations were made.
- Dividend yield. The dividend yield is the ratio between a company’s annual dividend and its current share price. It is expressed as a percentage rate that shows the amount of money out of the price, which you would receive as a dividend from the company. For instance, Apple Inc. has paid an annual dividend of $3.08 in 2019. As of March 2020, the current stock price would result in a dividend yield of approximately 1.25% by simply dividing the annual dividend with the current share price.
Please note that a higher dividend yield doesn’t necessarily suggest a better stock pick. However, it does provide useful insight into the amount of value, which investors get for the price.
- Price to free cash flow. The free cash flow (FCF) of a company is important because it essentially represents the efficiency of a business to produce cash, which then can be further returned to its shareholders or reinvested back into the business.
A low price to FCF ratio can indicate that a company is undervalued and rather cheap in comparison to its amount of free cash flow. Value investors usually favor companies with low P/FCF ratios since it indicates that an efficiently cash-flow producing business may be priced at a bargain for its value.
The Intrinsic Value
While the value of a stock can be quickly assessed by applying the value metrics mentioned above, more advanced value investors usually determine the value of a stock by calculating the so-called intrinsic value. The Intrinsic value or fair value is the exact value, which the investor considers the stock to be really worth. To really find the margin of safety and the amount of discount you are paying for a stock, you would need to calculate the exact fair value, in other words, the real price that you consider a company is worth.
Determining the intrinsic value is certainly not as simple and easy, as applying financial metrics such as P/E ratio, P/B ratio, and the dividend yield. That being said, there are several methods of calculating the intrinsic value of an investment. The most commonly used approach is the Discounted Cash Flow (DCF).
Value investing has historically proven to be extremely profitable to investors. Warren Buffett has beaten the market for multiple decades in a row with his own individual investing approach based on fundamental value investing principles. Value investing is not one single investing strategy that each and everyone can apply but rather an investing philosophy followed by the many successful investors that are looking to make consistent long term returns out of businesses and not stock fluctuations. That being said, the core of value investing remains the same, which is to buy great businesses at a discount of their value.