# What Math Formulas Should I Know For The Act What is Value Investing?

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## What is Value Investing?

What is Value Investing?

Different sources define investment value differently. Some say that value investing is an investment philosophy that favors the purchase of stocks that are currently trading at low book value and high dividend yields. Some say value investing is about buying stocks with a low P/E. Sometimes you will hear that value investing has more to do with the balance sheet than the income statement.

In his 1992 letter to Berkshire Hathaway shareholders, Warren Buffett wrote:

We think the term “investment value” is unnecessary. What is “investment” if not the act of seeking at least enough value to justify the money paid? By consciously paying a stock above its calculated value – in the hope that it can soon be sold at a higher price – it should be labeled as speculation (illegal, immoral or – in our opinion – financial gain).

Appropriately or not, the term “investment value” is widely used. Generally, it involves buying stocks with characteristics such as a low price-to-book ratio, a low price-to-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they seem to be combined, are not far from determining whether the investor is buying the right thing and therefore is really working on the principle of getting value from his investment. Accordingly, the opposite characteristics – a high ratio of price to book value, a high ratio of earnings, and a low dividend yield – do not correspond in any way to the “value” of the purchase.

Buffett’s definition of “investment” is the best definition of value available. Value investing is buying a stock for less than the calculated value.

Principles of Value Investing

1) Each share of stock is an ownership interest in the underlying business. A stock is not just a piece of paper that can be sold at a higher price at some future date. Shares represent more than the right to receive future cash dividends from the business. Economically, each shareholder has an undivided interest in all of the company’s assets (tangible and intangible) – and should be valued as such.

2) Stocks have intrinsic value. The value of a stock is derived from the economic value of the underlying business.

3) The stock market is inefficient. Value investors do not subscribe to the Efficient Market Hypothesis. They believe that stocks often trade at prices above or below their intrinsic value. At times, the difference between the market price of a share and the intrinsic value of that share is wide enough to allow a profitable investment. Benjamin Graham, the father of value investing, explained the inefficiency of the stock market using a metaphor. His metaphor of Mr. Market is still referenced by value investors today:

Imagine that you own a small share in a private business worth \$1,000. One of your colleagues, named Mr. Market, you really have to. Every day he tells you what he thinks your interest is worth and offers to buy or sell additional interest on that basis. Sometimes his value proposition seems believable and is proven by business development and prospects as you know. Usually, on the other hand, Mr. Market lets his enthusiasm or his fear run away with him, and the price he raises seems short to you.

4) Investing is smarter when it works better. This is a quote from Benjamin Graham “The Intelligent Investor”. Warren Buffett believes it’s the most important investment lesson he’s ever been taught. Investors should treat investments with the utmost respect and learning from those who handle their chosen profession. An investor should treat the shares he buys and sells like a store owner would treat the stock he works in. He should not make commitments for which his “marketing” knowledge is insufficient. Moreover, he should not engage in any investment activity unless “reliable calculations show that it has a reasonable chance of generating a reasonable profit”.

5) True investing requires a margin of safety. A margin of safety can be provided by the firm’s working capital situation, past earnings performance, real estate assets, economic goodwill, or (usually) a combination of some or all of the above. The margin of safety is expressed in the difference between the quoted price and the intrinsic value of the business. It absorbs all the damage caused by the investor’s inevitable miscalculations. For this reason, the margin of safety should be as wide as we humans are stupid (ie it should be a real gap). Buying dollar bills at ninety-five cents only works if you know what you’re doing; Buying bills on the dollar at forty-five cents seems profitable even to ordinary people like us.

What is Value Investment Not

Value investing is buying a stock for less than the calculated value. Surprisingly, this fact alone separates value investing from other investment philosophies.

True growth (long-term) investors like Phil Fisher focus solely on the value of the business. They don’t care about the price paid, because they only wish to buy shares in really unusual businesses. They believe that the phenomenal growth that such businesses will experience over many years will allow them to benefit from the wonders of mergers. If the value of the business compounds quickly enough, and the stock is held long enough, even the seemingly high price will be justified in the end.

Some so-called value investors consider relative prices. They make decisions based on how the market values ​​other public companies in the same industry and how the market values ​​each dollar of earnings available across industries. In other words, they may choose to buy a stock because it seems small compared to peers, or because it trades at a lower P/E than the general market, even though the P/E ratio doesn’t seem too low. wholly or historically.

Should such an approach be called value investing? I don’t think so. It may be a perfectly valid investment philosophy, but the different investment philosophy.

Value investing requires the calculation of intrinsic value independent of market value. Expertise that is supported solely (or primarily) on the basis of evidence is not part of value investing. The teachings laid down by Graham and expanded upon by others (such as Warren Buffett) form the foundation of a logical structure.

Although there may be active support for value investing techniques, Graham established a very rational school of thought. Correct reasoning is based on proven concepts; and causal relationships are emphasized in correlational relationships. Value investing can be a lot; but, arithmetically quantitative.

There is a clear (and pervasive) difference between fields of study that use calculus and fields of study that are purely arithmetical.. Value investing considers security analysis as an arithmetical field of study. Graham and Buffett are both known to have stronger natural math skills than other security analysts, yet both men say the use of advanced math in security analysis was a mistake. Real value investing requires no more than basic math skills.

Alternative investing is sometimes thought of as a subset of value investing. In fact, those who call themselves value investors and those who call themselves contrarian investors tend to buy the same stocks.

Let’s consider the case of David Dreman, author of “The Contrarian Investor”. David Dreman is known as a contrarian investor. In his case, it’s an appropriate label, given his strong interest in ethical finance. However, in most cases, the line that separates the value investor from the illegal investor is not very clear. Dreman’s investment strategies are based on three steps: value to earnings, value to cash flow, and value to book value. These same measures are closely associated with value investing and in particular the so-called Graham and Dodd investment (a type of value investment named after Benjamin Graham and David Dodd, co-authors of “Security Analysis”).

Conclusions

Finally, value investing can only be defined as paying less for a stock than its calculated value, where the method used to calculate the stock’s value really depends on the stock market.. Where intrinsic value is calculated using discounted future cash flow analysis or asset prices, the resulting intrinsic value estimate is independent of the stock market. But, a strategy based on simply buying stocks that trade at a lower price-to-earnings, value-to-book, and value-to-cash flow flows relative to other stocks is not worth investing in. Certainly, these strategies have proven to work well in the past, and will continue to work well in the future.

The magic formula devised by Joel Greenblatt is an example of one effective method that will consistently lead to portfolios like those built by true value investors. However, Joel Greenblatt’s magic formula does not attempt to calculate the value of purchased goods. So, while the magic formula may work, it is not a true investment value. Joel Greenblatt himself is a value investor, because he calculates the intrinsic value of the stocks he buys. Greenblatt wrote The Little Book of Beating the Market for an audience of investors who lack the ability or inclination to value businesses.

You cannot be a value investor unless you are willing to calculate business values. To be a value investor, you don’t have to value the business correctly – but, you must value the business.

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