Value investing is when you buy a share that is trading for less than the combined value of all its bits and pieces.
The trick with value investing is to find valuable, high performing businesses the rest of the market is pessimistic on.
Sure, sounds like a simple and effective strategy. (And kind of obvious).
But the difficulty with value investing can lie in the actual analysis of the business, how it operates and what its future earnings look like.
And the most important question of all is, why has everyone missed it?
You can find the intrinsic value of a business by calculating both tangible and intangible factors.
Tangible factors are things, like buildings, equipment and products.
Intangible factors are non-physical things, like brand recognition, copyrights and trademarks, intellectual property and goodwill.
You take those things into account as well as things like the broader economy and the industry, financial conditions and how the business is managed.
Basically, you want to consider anything that would affect the value of the business and then you compare it to what the market says.
Scrutinising the financials of a business gives a powerful insight into how you might value it.
The likes of Warren Buffett pore over the accounts of any business they are looking to buy.
They will look at things like revenues, earnings, future growth, return on equity, profit margins, and other information to determine a company's underlying value and potential for future growth.
Once they decide on a value for a business, they then compare it to what the market says, in the form of the share price. They are looking for cases where they believe the market has mispriced the company.
Of course, the problem with value investing is two investors can look at precisely the same information and give the business a different value.
Margin of safety
In order to combat the chance of error, value investors will generally impose a ‘margin of safety’ buffer.
That means they want to find a business that is not just below the market value, but significantly below it.
That way, if the share prices don’t do what the investor anticipated, they have minimised their risk.
Everybody bangs on about how efficient the market is (at least, economists do), so how would millions of investors miss the opportunity to own an undervalued business?
The truth is, there are way more emotions involved in investing than people like to admit.
And so when news about the economy or businesses or anything at all really filters through to investors, they sometimes react by buying and selling shares.
This results in price movements and is generally known as the ‘market sentiment’.
But market sentiment often has very little to do with the actual value of a business and value investors generally don’t get swept up in euphoric bull markets or panicked bear markets.
Because they’ve done their fundamental research, value investors often buy up shares when the market has sold off or sell their shares when the market is exuberant.
It’s important to remember that market sentiment can often cloud the judgement of investors, especially when they read a lot of news media.
Ignore the crowd!