1 Answers: An Example of Value Investing Success


I have been looking at the differences between growth stocks and investing and Value Investing and have arrived at the conclusion that longterm Value Investing is the best investment strategy.

Can someone give me an example of successful value investing and how it works?

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Jones 4 years 1 Answer 775 views 0

Answer ( 1 )

  1. Recently I posted about this on another part Asking Investors when I talked about with Buffett.

    Value investing involves looking for undervalued stocks whose prices are cheap relative to what they are actually worth.

    The most important tool a value investor can have is time.

    If you don’t invest time and effort into looking for companies, you won’t reap the benefits.

    Here’s Warren Buffett speaking to a group of Columbia Business School students and talking about the importance of investing time to do your research.

    Let’s recap what Buffet and other value investors look for: The first trait is that the company should be simple and easy to understand.

    We’ve talked about this many times but it’s something you can’t forget if you plan on doing well.

    A good example of this is that Buffett himself missed out on the tech bubble of 2000 as he didn’t understand technology companies.

    As you probably know, by 2001, many of those tech company lost over 70% of their share prices while others went bankrupt.

    You should look for companies with aa strong brand image.

    Businesses like coca cola or McDonalds are known across the world and have a stable customer base.

    These are the types of companies that are deemed safer than the average and that can present tremendous value.

    Next is to look at earnings.

    Again, Coke and McDonalds have seen increasing earnings over a long period of time, which is what fueled their stock prices to move higher.

    Last but not least is management.

    The reason why management is so important is that whoever leads the company also determines how it will perform financially.

    A good CEO can make a business prosper during an entire lifetime and can even rescue a company during tougher times.

    Just remember, when you invest in a business, you are also investing in the management team.

    Alright so how do you determine whether a company is overvalued or undervalued.

    There are two main ways to do this: either by relative or absolute valuation.

    For the purposes of this video, we will focus on relative value.

    Basically, relative valuation involves comparing a company to its competitors in the same industry and we mainly do this using ratios.

    There are many metrics you can apply but one of the most important ones is the price to earnings ratio, or PE ratio.

    You get the figure by dividing price by earnings.

    The rule of thumb is that the higher the PE ratio compared to competitors in the same industry, the more overvalued the stock is, while the lower the ratio, the more undervalued it is.

    Let’s say Apple is trading at a PE of 20, which we get by dividing the stock price of $200 by earnings of $10 per share.

    On its own, we can’t really understand its value but if we compare it to Microsoft, whose PE is 25, we can determine that Apple is undervalued relative to its peer.

    Another important metric is the Price to Book ratio.

    In general, book value is a rough estimate of how much a company is worth.

    The abbreviation for this is P/B and is calculated by dividing price over book value.

    If Apple’s PB is 14 and Microsoft’s is 16, Apple is undervalued in terms of book value relative to Microsoft.

    Finally, the last crucial metric that I like to look at is the debt to equity ratio.

    As we saw from some of the legendary investors, they warn against investing in companies that carry too much debt, so businesses that have taken out lots of loans.

    The debt to equity ratio looks at the amount of debt in relation to a company’s shareholder equity, which if you remember is calculated by subtracting liabilities from assets, and is the net worth of a company.

    The lower the ratio, the better.

    If Apple has a debt to equity ratio of 0.31 and Microsoft is at 0.33, then Apple is more attractive as it carries less debt.

    Now let’s look at another way of figuring out value.

    This one’s a little bit more tricky and can be incredibly complex, so I’ll simplify it as much as possible.

    Remember how we talked about the intrinsic value of a stock?

    If you don’t remember, the intrinsic value is the true value of a stock and value investors try to buy when the current market price is below the intrinsic price.

    Right now we’ll try to figure out a form of intrinsic price for Apple using random numbers.

    Let’s say Apple sells 100 million products per year at an average price of $1000 each, making $100 billion in sales.

    To make those 100 million products, they have to spend $800 dollars which are the costs.

    This means they are personally making $200 per device, so $20 billion.

    Obviously, Apple is a business and businesses want to grow.

    Let’s say that Apple sells 5% additional product each year at the price of $1000.

    So next year they make $22 billion, and the year after they make $24.2 billion.

    For the next 39-40 years, we predict they will make 337.5 billion.

    If you divide that by the total number of shares, we get a value of $55 dollars per share.

    That is the intrinsic price.

    If we were to say the current market price is $40, that represents upside of 37.5%.

    This means that Apple is undervalued.

    As you can see, the most important factor for a business is growth and growth in earnings.

    if a business can consistently grow its profits, higher stock prices will follow.

    That’s pretty much it for value investing.

    If you’re just starting out, I advise you focus on relative valuation and figuring out how a company compares to competitors in the industry.

    Its not only an easy way of valuing a business but it can give you a very precise indication of what investors are willing to pay for peers in the industry.

    Absolute valuation is also very useful but at the same time much more complex, and requires you to forecast free cash flow and determine things like the weighted average cost of capital.

    These are things that you will learn with time and as you look at more companies.

    In the end, as Warren Buffett himself said, only by investing time in your research, will you be able to do well as an investor.

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