What is value investing?
Value investing means first estimating a company’s real, or “intrinsic”, worth from its earnings, assets, debts and prospects. Only if the share price is well below that estimate do you consider buying. The core belief is that the market sometimes pushes the price of a sound business unreasonably low out of fear or gloom.
Benjamin Graham is regarded as the father of this approach. With David Dodd he wrote “Security Analysis” in 1934, and on his own “The Intelligent Investor” in 1949. He taught at Columbia Business School, where one of his students was Warren Buffett.
Say a good second-hand fridge is for sale after Eid. It runs like new and, even allowing for repairs, is worth at least Tk 20,000. The owner is moving house and lets it go for Tk 13,000 in a hurry. If you can check both that it is sound and that the price is below its worth, that is what a value investor would call an “opportunity”. The numbers are only an example.
Why it matters to an investor
- To separate price from value: price is what the market asks today; value is what the business is really worth. They are often not the same.
- To leave room for error: estimates can be wrong, so buying well below value gives some protection if you are.
- To resist rumours and herd buying: it builds the habit of buying because the numbers work, not because everyone else is.
- To appreciate patience: an underpriced share may take years to reach its value, or may never get there.
Graham’s two key ideas
Margin of safety: the gap between your estimate of value and the price you pay is your safety cushion. Buying a share worth Tk 100 for Tk 70 gives a 30% margin. If your estimate is somewhat wrong, the gap can absorb part of the mistake.
Mr Market: Graham pictured the market as a moody business partner who turns up every day offering to buy or sell your share at a different price. Some days he is over-excited, some days deeply gloomy. You do not have to listen to him; you can take his price only when it suits you.
What value investors look at
- P/E ratio: how many times earnings per share (EPS) the price is. A relatively low P/E can sometimes signal a low price.
- P/B ratio: the price compared with net assets per share (book value).
- Debt and cash flow: low debt and steady cash coming in make it easier to survive bad times.
- Business quality: whether earnings are durable, whether it can hold its own against competitors, and whether management is transparent.
The value trap: cheap for a reason
A low P/E or low price is not automatically an opportunity. Often the price is low because the business really is getting worse: earnings falling, debt rising, questions about the accounts, or a product that no longer sells. Buy that and wait, and the price may fall further. This is called a value trap.
So value investing is not hunting for cheap shares, but for sound businesses priced low for temporary reasons. Telling the two apart takes both reading annual reports and patience.
Worked example
- Say you estimate a share is worth Tk 100 and the market price is Tk 70. Margin of safety: (100 − 70) ÷ 100 = 30%.
- Later it turns out your estimate was too optimistic; the true value is Tk 85. Bought at Tk 70, the share is still Tk 15 below that value.
- Had you paid Tk 95 for the same share, with a true value of Tk 85 you would have paid Tk 10 more than it is worth.
Result: a margin of safety does not prevent mistakes, but it softens them. And there is no guarantee when, or whether, the price will move towards the value. The numbers are only an example.
Common mistakes
- Thinking “it has fallen a lot, so it must be cheap”. What the price used to be is no measure of value.
- Deciding on one ratio alone, such as a low P/E, without understanding the business or its debts.
- Treating your own estimate as certain. Value is a rough range, not one exact number.
- Giving up when the price has not risen in a few months, or the opposite: clinging on with “it will come back one day” while the business is clearly getting worse.
Price is what you pay, value is what you get: value investing is about finding the gap between them, and leaving plenty of room for being wrong.