Buying stocks for less than they are worth
Value Investors profit by buying stocks at discounts to intrinsic value
Value Investing is a strategy that seeks to buy stocks trading at discounts to intrinsic or private market value. The value investor profits by focusing on business fundamentals rather than price speculation.
Value Investing is the purchase of stocks for less than they are worth. A value investor seeks to buy the shares of a publicly traded company when its market price trades at a discount to the company’s true or intrinsic value. The value investor expects that at some point in the future the company’s discounted price will rise and reflect the full value of the company. At that point, the investor may sell for a profit.
Any shopper who hunts for bargains is using the same basic approach as the value investor: Understand what an item or product’s true value is, then buy when it’s “on sale” for less than its actual worth.
A key distinction between value investing and other trading and investing strategies is that the value investor analyzes the business fundamentals of a company, not the price movement of its stock. Value investing is about studying and investing in businesses. Trading is about speculating on the direction of market prices.
Value investors believe there is a difference between the value of a company and it’s stock price. The assumption is that markets are not efficient and that the market is often wrong about the true worth of a company -- sometimes very wrong.
Intrinsic value is the key concept at the heart of value investing. Before you can determine if a stock is a bargain, you must know what the underlying company's actual value is.
Today’s markets offer investors and traders instant liquidity -- you can buy or sell equities at any time of the day (or night). But this hyper-liquidity can obscure a basic fact: When you own a stock, you own a fractional share of a business. As a shareholder, you own a piece of the underlying company’s buildings, equipment, bank deposits, patents, income, etc.
The intrinsic value of a company is the total value of all these pieces of a business. The famous value investor Mario Gabelli calls intrinsic value “private market value” -- the amount that a private investor would be willing to pay for a company, in its entirety, were it not public. If you can buy a company at a large discount from this real-world value, you stand a good chance to profit, while also reducing risk.
Here’s an example of a value investing approach toward buying a private business:
Let’s say you meet someone who owns a coffee cart -- an espresso machine on wheels which she rolls out for events like farmer’s markets, business conferences, etc. Her business is booming, but she is looking to sell. You express interest, so the owner sends you an income statement, balance sheet and other information. But how much is the coffee cart worth?
First, you might determine the value of the hard assets: the espresso machine, other equipment, the cart itself. She also has contracts to supply coffee exclusively for various events on an ongoing basis -- that’s guaranteed future income. In addition, she has developed a reputation for quality products and has built a distinctive brand. You take into consideration all these factors and determine that the intrinsic value of the coffee cart business is about $50,000.
So what do you offer the coffee cart owner for the business? Any good bargainer would offer a low number. You might offer $30,000 -- that would be a great deal, a 40% discount to “fair value.” Now if the coffee cart seller counters with a $35,000 offer, you may buy the business, confident it's a good deal, well below intrinsic value. However, if she says the price is $60,000, nothing less, you would politely decline, and move on to look elsewhere for businesses to invest in.
So it is with value investing. The first task is to determine the fair value of a publicly traded stock. If a company’s share price does not trade at a sufficient discount to intrinsic value to make a purchase attractive, you are free to move on and look elsewhere.
So how do you figure out the true business value of a stock?
Here are a few ways value investors determine intrinsic value:
- What are the assets worth? One way of determining intrinsic value is by adding up a company’s assets, both tangible like equipment and intangible like brand value, then subtracting its liabilities.
- What will it earn in the future? In some value investing models, the sum of the present value of all future income and cash flows is the intrinsic value.
- What are similar businesses selling for? Sometimes the buy-out of a public company indicates that similar companies are trading below intrinsic, private market values
Value investing is a term that describes a variety of fundamental investing approaches. What all these approaches have in common is the belief that stock prices are often wrong when it comes to valuing companies.