If you are already investing, you have probably heard about value investing. You might also hear about other investment styles except value investing. All these investment styles have different audiences. If you get excited about value investing, it might be your thing. You might also just want to learn what it is. Either way, there are many things to discover.
There are different types of investments that have different aims. Some focus on capital increase, cash flow, or something else. Value investing is probably the most famous. You probably see it frequently with dividend investing.
Many famous investors we know in our age are value investors. Perhaps the most famous one is Warren Buffet. However, he is not the only one. There are many more. Benjamin Graham is another example of the author of one of the most influential investing books. He is also Buffett’s lecturer and mentor. Charlie Munger is also a famous example famous for his investments. Christopher Browne is another Graham protégé and a value investor. Lastly, billionaire hedge-fund manager Seth Klarman is also a value investor.
If all this is impressive to you, this is just the beginning. If you want to start doing value investing, you are in the right place. Let’s see how value stock investing works and explain what is value investing.
What is Value Investing?
Value investing definition is simple. A value investing technique is about selecting stocks with discounted prices. You determine these discounted prices by many metrics. Their intrinsic or book value is the main metric that you look at. Value investors always look for stocks that they believe the stock market is undervaluing. They believe that the market overreacts to both positive and disappointing news. That this news leads to stock price swings. Swings that do not correlate to the long-term characteristics of a business. This overreaction provides an opportunity to benefit by purchasing equities at a discount.
Several reasons a company may price at a discount to its intrinsic value. The most frequent is short-term earnings disappointments. This frequently results in a significant decrease in stock price. These disappointments often create a strong emotional response among shareholders. In response, they sell their shares in fear of additional unfavorable events.
Finding and buying stocks that seem to be trading at a discount is a part of value investing. All value investors need to do is hunt these stocks. They buy to hold, but they hold shorter than most others. Their whole plan is to know the businesses well enough to profit from the wrong outlooks. They are actually similar to dividend investors. Both look at the quality of the company rather than short-term swings. One buys to hold forever, and the other tries to find the weakest spot. The latter buy to sell at a good profit at a later date. This could be a long-term or a short-term date.
Understanding Value Investing
Value investors recognize two things. For starters, most businesses are long-term in nature. The impact of short-term earnings on a company’s long-term worth is not parallel. They also recognize that most corporate earnings revert over time. In other words, terrible profit drops are mostly not frequent over the long term. Extraordinarily high-profit growth tends to decline.
You must look at many company metrics when you are a value investor. That’s why picking stocks by value investing requires a good understanding. Understanding both the numbers and the business is important. There are many examples that one or the other didn’t fit well. Perhaps the biggest example is Enron. If you failed to understand both sides of the understanding, you would be one of those to lose money on Enron.
The metrics to look at may include various things. Earnings Per Share (EPS) and Price-to-Earnings (P/E) are the most famous ones. Price-to-book (P/B) and price/earnings-to-growth (PEG) are equally important metrics. In addition, debts, revenues, and profits determine the big picture. P/B and P/E ratings give you a more concrete picture, and that’s the reason why they are famous.
An old Warren Buffet & Benjamin Graham trick uses these two metrics. They use them to determine a company’s profitability. These equations also show whether it is under or overvalued. They would look for a P/E rating of less than 15 and a P/B of 1.5 or less. They would find companies under these numbers. Once they find these companies, they multiply their P/V and P/B. If the value is under 22.5, the company might be trading at a discount.
How Do You Calculate Metrics for Value Investing?
The Price to Book ratio, often known as the P/B ratio, measures a company’s stock price to its book value per share. This measurement and metrics are perhaps the most famous. By looking at this, you could get a good idea. Yet, it doesn’t mean that it will show you everything. The book value per share has a special calculation. You divide the company’s net worth by the number of outstanding shares. A company’s net worth is its assets minus liabilities. In principle, any score below 1.0 could show that its price is undervalued. This means that a company’s stock is trading for less than its net worth.
During certain economical situations, this ratio could fluctuate. Right now, certain banks are now trading under their book value. The current economic situation with interesting rates indicates that. In addition, some growth firms are trading at many multiples of their net worth. However, there is not one P/B ratio that indicates value vs. growth investments. These figures fluctuate during company cycles. When stock prices rise, the P/B ratio increases, and when prices fall, the ratio decreases.
The P/E ratio reflects the price of a firm’s stock to its yearly earnings. A P/E ratio of 15 shows that it will take 15 years to match the stock price at the company’s present profits. The smaller the P/E ratio, the more probable the firm is, thus, a value stock. No set threshold qualifies a share as a value investment. However, something to remember is that the PE ratio should be less than the market’s average P/E ratio. It is also worth remembering that each sector might have different ratios. For example, REITs generally do not follow certain P/E and P/B values. You generally shouldn’t consider them. You must look at FFO or AFFO.
Like with the P/B ratio, a lower P/E ratio does not always indicate that a firm is a good investment. These indicators can be a starting point for future investigation. P/E and P/B are the two most famous indicators. They generally show you the big picture. They will likely make your time in research easier if they are good enough.
Fundamental Metrics for REITs
Even though most stocks are similar, REITs are generally not. This also counts in researching them. Looking at traditional metrics does not show you the big picture with REITs. You have to look for other specific metrics. These metrics will show you a better picture for REITs only. After all, REITs are special stocks.
Funds from Operations (FFO)
The National Association of Real Estate Investment Trusts created a special metric. This trust is also known as NAREIT. This metric is “funds from operations” (FFO). This became a standard industry term. You can calculate it yourself. GAAP net income + amortization and depreciation minutes profit from the sale of real estate. Since you subtract non-cash expenses from GAAP net income, FFO is more important. It gives you a better picture of earnings than the traditional P/B ratio. Non-cash expenses are the depreciation and amortization of a REIT.
Since real estate value increases over time, this shows lower earnings per share. Because there are low earnings per share, the payout ratio will seem high. That is why this might also not be the only way to understand whether a REIT is profitable or not. It is no secret that it could also be a good point to start doing your due diligence.
Shortly, FFO is a much better method of estimating a REIT’s operating cash flow. It offers stronger indicators of how secure its dividend actually is.
Adjusted Funds from Operations (AFFO)
Contrary to FFO, AFFO is a little more difficult to calculate. There is no standard formula that all REITs can just use. However, in most cases, there is a common AFFO calculation. You deduct maintenance expenses from FFO (operating cash flow). You then account for something known as straight-line lease revenue.
This is when a REIT changes its lump-sum rent payment into quarters. This helps to represent rent per quarter when tenants pay in one lump payment upfront. You also add the costs associated with debt and equity issues back into AFFO. REITs do this because debt and equity issuance is a cost of growth. A REIT’s business model depends on financing growth by outside debt and equity investors.
To put it another way, AFFO is comparable to a REIT’s free cash flow (FCF). Most corporations keep their earnings and cash flow to fund their growth internally. Free cash flow is the operating cash flow – maintenance and growth capital investment. However, since REITs grow with external debt and resources, you only exclude maintenance expenses. You also remove anything related to external capital.
Some REITS use the term “Funds available for distribution,” or FAD to refer to AFFO.
Risks of Value Investing
Value investing is a low- or medium-risk technique. Yet, just like any other investment technique, it has its risks. Because you try to bet on companies to grow, you take on risks. This risk could result in losses for your money. The company might not take the turn you want. Eventually, you are betting on the current metrics and future plans. If those plans do not hold, your investments will go in vain.
When making value investing decisions, most investors rely on financial figures. So, if you depend on your research, be sure you have the most up-to-date data and that your estimates are correct. Otherwise, you risk making a bad investment or missing out on a good one. Always study these metrics and financial figures. Even if you are not confident in understanding and evaluating them. Just study them and look at the numbers. Do not make any trade or investment until you have the necessary information. Use your first time in the research as a learning period.
Some events that appear on a company’s balance sheet might be exceptional. This refers to events that do not happen frequently. These are beyond the company’s control and are unique. It could be a gain or an extraordinary loss. Suits, restructuring, and even natural disasters are among the instances. If you omit these from your study, you should be able to predict the company’s future success.
Dividend Investing vs. Value Investing
Value investing is not the only way to choose stocks. There are also other strategies. One of those strategies is dividend investing. It is an exceptionally famous strategy. Many people start investing in stocks because of dividends. It works really well in the long run, but it’s not a good fit for everyone. Value investing seeks out firms with cheap stocks. Dividend investment seeks out companies with a stable track record of dividend payments. On top of the dividend payments, you also look for good financial records. There are more to look at. However, you spend less time on the continuous research of the companies because you don’t buy to sell.
A value investor may aim for a low P/E or P/B ratio. But a dividend investor focuses on the company’s financial strength and dividend safety. Both techniques have the potential to beat average market returns over time. They only serve different purposes. The dividend is more for cash flow, and value investing is more for capital increase. If you need cash flow, value investing might not be a good choice for you.