What is Value Investing and How Does It Work?

Value investing focuses on analyzing companies with a bottoms-up approach and identifying stocks that are presently trading below their “fair value”.

Value investing gained popularity under Benjamin Graham and David Dodd of Columbia Business School.

The duo propagated an ownership mindset and suggested rigorous financial analysis to make investments in companies trading below their intrinsic value. 

By making investments at a lower price than the theoretical fair value, investors are able to build a margin of safety and minimize the downside in case the investment thesis is proved wrong. 

While modern-day value investors ascribe to their original works, notable investors such as Warren Buffett and Bill Ackman have adopted an improvised framework focused on investing in simple, predictable, free cash flow generating businesses that are selling at a discount.

Amongst different investing styles, value investing is probably the cornerstone and fundamental block behind several of the most successful and notable asset allocators in recent history. 

How to be a Value Investor

The steps involved in operating as a value investor are often non-linear and involve a strong background in reading and analyzing financial statements along with a passion for understanding valuation principles to ascertain – within a reasonable degree of accuracy – how different companies are valued in different sectors.

Furthermore, value investors are patient, long-term oriented and aspire to develop an ownership interest in companies rather than have a trader’s mindset of quick entries and exits for short term gains.

Important Value Investing Metrics

Listed below are some of the critical metrics that value investors closely track to identify securities trading below their intrinsic fair value.

1. Price-to-Book Ratio

The price-to-book ratio is obtained by dividing the book equity as per the financial statements (Assets less Liabilities) and the market capitalization of the company.

This ratio signifies what premium or discount the marketplace ascribes to each dollar of book equity to own this company.

However, like any data point, it cannot be used in isolation.

Without the relevant context, European and Japanese banks have traded at a discount to their book value for years, investors use this metric alongside a number of other data points.

From a value investing standpoint, investors want to buy companies trading less than the book value, as it implies the value of the company in the marketplace is discounted compared to the book value of its net assets. 

2. Price-to-Earnings Ratio

As the name suggests, the price-to-earnings is the ratio of how many multiples of earnings the stock price is trading at.

The P/E ratio measures the extent of overvaluation or undervaluation in a particular stock and how much investors are willing to bid up the price based on a future earnings multiple.

This ratio can be useful to value investors as they can find undervalued stocks which are selling at a lower P/E, indicating a stock is cheaply priced to its earning potential.

The P/E ratio does have its own limitations as it’s mainly useful to compare companies within the same industry and not different sectors.

For example, the P/E of a downstream oil company vs. SaaS technology company can’t be viewed in the same light due to the different revenue and earnings profiles of both sectors.

Also, the P/E ratio has limitations in factoring in any earnings growth as well.

Investors fall back on using the PEG ratio, which discounts the P/E Ratio by the Earnings Growth to factor in the growth in earnings,

3. Debt-Equity Ratio

CFOs and the management of any company have to deliberate on what is the best way to fund the assets and operations of the company.

By choosing to employ debt in the capital stack, the company can utilize financial leverage, benefitting from debt interest payments that are tax-deductible, and the fact that debtholders do not have a stake in the company’s ownership.

As a result, for operationally sound businesses, the management can pull on the debt lever to enhance the earnings per share delivered to stockholders.

Value investors use the debt to earnings ratio to determine the safety of investment as companies with lesser debt will have more capacity to take on debt obligations if needed.

Further, industry and business type affect the capital stack, so it will be unyielding to compare the debt to equity of a utility company with that of a real estate company.

However, by making comparisons within the same industry, value investors can identify safer bets to make depending on the investing climate and business cycle.

4. Free Cash Flow Generated

Businesses function to convert inputs, serve customers through products and services and convert those sales back into free cash flow for the enterprise.

The free cash flow generated by operations is what is left after all operational and capital expenditures are paid before the debt and equity holders can be paid.

On a side note, although debt payments have preferential tax treatments (interest paid on debt is tax-deductible, thus lowering the cost of debt), they are not used to calculate the free cash flow number as debt taken is a choice exercised by the management and not an inherent characteristic of the operations of the business.

Value investors focus on distinguishing between investing opportunities using the free cash flow generated by operations to identify potentially undervalued companies that are sound operators in a steady, profitable industry.

5. Return Ratios

Oftentimes, by adequately scrutinizing financial statements and measuring certain return ratios, investors can get a pulse check on the return characteristics of the particular business and discern between good and bad businesses in order to further dig into their investment thesis.

  • Return of Capital Employed (ROCE): ROCE measures returns for all sources of capital for an enterprise and is obtained by dividing the Earnings Before Interest Tax (EBIT) by the capital employed. This is usually expressed as a percentage.
  • Cash Return on Capital Invested (CROCI): CROCI is similar to the ROCE, but is expressed in terms of the free cash flow generated by the firm. It is derived by taking the free cash flow to the enterprise and dividing it by the capital employed.
  • Return on Assets (ROA): ROA is pretty straightforward as it takes the Profit after Tax number and divides it by the Total Assets number.
  • Return on Equity (ROE): ROE is similar to ROA, but instead of using the Total Assets, ROE uses the Total Equity to determine profits made for the shareholder in percentage terms.

These ratios all measure returns in terms of net profit and cash flow for the firm and shareholders to determine optimal capital allocation, as well as, identify key performance drivers.

A high ROE, but lower ROA, probably indicates the company is using cheap debt and financial engineering manoeuvres to deliver those profits while a rising CROCI/ROCE might indicate a solid business in a growing industry.

Pros of Value Investing

1. Margin of Safety

The underlying premise of value investing is that you invest in companies that are selling at a discount to fair value in stable, growing industries to produce predictable free cash flow. 

2. Restricts Speculation

Value investing can be considered boring and vanilla by certain market participants.

But this seemingly mundane investing profile seeks to utilize the certainty of a proven business model, strong operational performance and long-term compounding to grow the investment, rather than focus on disruption and innovation that will cause industries to be transformed.

The simplicity and predictability of these underlying businesses takes out reckless speculation. 

3. Tax Treatment

Value investors often hold investments for extended periods of time and are passive once the investment is made in an attempt to compound their returns.

As a result of the long time horizon, investors are not subject to constant portfolio churn and avoid paying short-term capital gains on their investments.

Guy researching value investing stocks

Cons of Value Investing

1. Fundamental Analysis

While value investors are known for conducting extremely diligent financial analysis to ascertain the fair value of the company, most investors have a steep learning curve to absorb complex financial statements produced by publicly listed companies and might need an accounting or finance background to best understand the details.

2. Efficient Capital Markets

With the passage of time, more and more market participants are analyzing the same set of investment opportunities using a fundamental, value investor lens which means any edge is getting arbitraged out, thereby making profitable investments harder and harder to discover.

While the investment principles are sound and bound to work in supportive market environments, caution and discipline in identifying opportunities will be critical to investment returns as a value investor in these markets.

3. Value Traps

Companies that are inexpensive remain inexpensive for long periods of time until there is an inflection point or catalyst that moves the market and provides investors more than a fundamental reason to participate in the story behind that particular sector or name.

Coal, uranium and fertilizer stocks are good examples that have seen gains based on the Russia/Ukraine conflict, but these sectors remained under-owned and their sudden outperformance is a direct result of the catalyst.

Value Investing Resources

Listed below are some great value investing resources:

Blogs/Websites

Books

  • The Intelligent Investor by Benjamin Graham and David Dodd
  • Poor Charlie’s Almanack by Charlie Munger
  • Margin of Safety by Seth Klarman
  • Mastering the Market Cycle by Howard Marks
  • Snowball effect by Alice Schroeder

Notable Value Investors

  • Warren Buffett/Charlie Munger – Berkshire Hathaway
  • Harris Kupperman – Praetorian Capital
  • Bill Ackman – Pershing Square Capital
  • Seth Klarman – Baupost Group
  • Howard Marks – Oaktree Capital

Frequently Asked Questions

  • Does value investing still work?
  • What does Warren Buffett mean by value investing?

Sid Mohapatra is an energy trader based out of Toronto working in power and natural gas trading. Prior to working in commodities, Sid worked at a top Canadian bank’s fixed income and derivatives business. He possesses strong fundamentals in asset allocation, global macro thematic investing and physical commodities.

As a graduate of McMaster University, Sid specialized in Finance and has taught numerous sessions on Investing, Financial Securities and Trading courses. He led and managed the Horizon’s Trading Center at McMaster University.

Sid’s unique experience brings a breadth of institutional knowledge to the retail investing universe. He covers equity derivatives, structured credit instruments and tax harvesting techniques to help Canadians make better financial decisions in the ever-changing landscape of financial markets and investing.