Explaining value investing
Q. I hear about value investing, but I’m not sure I understand what it means. Can you explain?
— Trying to learn
A. We’re glad you asked.
The basic idea surrounding value investing is very much what it sounds like: a focus on purchasing stocks that an investor believes to represent good “value” as far as the purchase price, said Charles Pawlik, a certified financial planner with Lassus Wherley in New Providence.
It is very much akin to going shopping and trying to find a good discount on your purchase, he said.
“Value investing aims to invest in stocks that are currently trading below what an investor determines to be/believes to be the actual value of the stock,” he said.
Pawlik offered this example: If a stock is currently trading at $50 a share and an investor believes the stock is actually worth $70 a share, a purchase of the stock based on this assessment would be an example of value investing.
The other primary investment style is known as growth investing, which focuses on companies determined to have signs of above average growth in terms of cash flow or earnings measures.
“Investors following the growth style of investing typically don’t focus as heavily on what the current share price of the stock is relative to what they believe to be the actual value, but instead focus on determining that signs of above-average growth for the company are present,” he said.
Value investing resulted from the investment ideas of famed investors and Columbia Business School professors Benjamin Graham and David Dodd back in 1928, and has been the foundation for many successful investors/money managers over the years including Warren Buffett, Pawlik said.
Although the basic idea behind value investing sounds relatively simple, one of the primary challenges is in determining what an investor believes to be the actual value of a stock, commonly referred to in value investing as its “intrinsic value.”
“This assessment of the estimated actual value or intrinsic value of a stock typically focuses on some measure of a company’s cash flow or bottom-line earnings, and seeks to determine what a reasonable amount to pay for those earnings may be in terms of the price to purchase the stock,” Pawlik said.
He said a common method of doing this is to assign some multiple on the estimated earnings of a company to determine what its share price should be. This is the basis behind a very popular fundamental metric used in the investing world to help determine if a stock might represent good value or is “cheap” relative to its peers in the industry, or if it is “expensive” on a relative basis.
This metric is the Price/Earnings or “P/E” ratio.
For example, Pawlik said, if the estimated earnings per share for a company is $5 a share and the P/E ratio is 10, the stock should conceivably trade at $50 a share.
“This signifies that investors buying the stock are willing to pay 10 times the estimated earnings per share for the company,” he said. “This P/E ratio of 10 can then be compared to other companies in the industry to assist in determining if the stock is either `cheap’ or `expensive’ on a relative basis.”
Pawlik said value investing would tend to focus on companies that have lower P/E ratios relative to other companies in the industry, meaning that investors are paying less for the earnings that are generated by that company.
Ultimately, a value investor is hoping that the current stock price will move up to their estimated value for the stock over time, he said.
There are a large number of fundamental metrics/characteristics that can be looked at for a particular company to determine if it may represent more of a value-type or growth-type investment, and sometimes the lines can be blurred between the two, Pawlik said.
And is value investing the best way to go?
Value investing has at times produced better returns than growth investing, as has growth investing produced better returns than value investing, Pawlik said. However, value investing has proven to be a sound approach to investing over time, and is the premise behind many of the strategies run by mutual fund managers today.
“By investing in mutual funds that focus on value investing, you can participate in this style of investing through a professional money manager that will select several different stocks they believe to be good value investments,” he said. “After all, who doesn’t like a good discount?”