Basics of Value Investing

The bet you are actually making

The last lesson laid out the investing styles. The next several lessons stay with one of them: value investing — buying companies whose share price looks low compared with what the underlying business appears to be worth.

Video coming soon

This lesson explains the idea in full without it.

That comparison needs a second number to compare the price against. That number is intrinsic value: your estimate of what a business is actually worth, judged from the business itself — what it earns, what it owns, what it owes, what it's likely to earn later. You arrive at it by working through the company's finances rather than by looking at its stock chart.

Once you have an estimate, the two words that follow are simple. A stock trading below your estimate is undervalued. A stock trading above it is overvalued. The bet is that the market eventually prices the company closer to what the business is worth — that undervalued stocks drift up toward your number and overvalued ones drift down toward it. You profit if the price comes to you.

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Value investing can be applied to anything that can be mispriced. This course stays with stocks in financially sound companies, because that's where the tools we're about to build work best.

Why this is a lot of work

Nobody publishes a list of undervalued stocks. If the market has a company priced wrong, finding out means reading its financial statements, comparing it against similar companies, forming a view of where its business is headed, and doing the arithmetic yourself. That's hours per company, and most companies you look at won't qualify.

Then comes the harder part. Even when you're right, being right takes time. The market has no schedule for agreeing with you, and it can spend years not agreeing. Your only options in that stretch are to keep holding a position that isn't working yet or to abandon it — and you cannot tell from the inside which one is correct.

So the honest description of the job is: substantial work up front, then patience with no confirmation. That's the price of admission. It's also part of why the opportunity exists at all — most people won't do it.

What value investing has going for it

A long history of being a real style, not a fad. Value investing has been practiced and studied for decades, and there have been long stretches where value stocks outperformed growth stocks — companies bought for their expected rapid growth rather than their current cheapness. Here's the part that usually gets left out: there have also been long stretches running the other way, where growth stocks left value stocks far behind. Leadership trades back and forth, sometimes for a decade at a time, and neither style wins permanently. A track record is evidence that an approach can work. It is not a forecast of your holding period, and anyone presenting it as one has picked their start and end dates for you.

Plot the two styles against each other over a long stretch of market history and you don't see a winner. You see the lead changing hands in runs long enough to feel permanent while you're living through them.

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Prices that have tended to move less. Volatility is how much a price swings up and down, usually measured against a benchmark — the index you compare performance to, such as the S&P 500®. Value stocks have historically shown lower volatility than growth stocks. That isn't magic; it follows from what value stocks usually are. Companies that look cheap relative to their earnings and assets tend to be established, mature businesses with a long operating record, and the market revises its opinion of those more slowly than it revises its opinion of a company whose entire case is what it might become.

Lower volatility means a smoother ride, not a safer outcome. A stock can fall a long way slowly. Read the risks below before you file "less volatile" under "less likely to lose money" — they are not the same claim.

Four ways this goes wrong

Value investing has risks that belong to it specifically, on top of the ordinary risk of owning stocks.

Company risk

Company risk is the risk that something is genuinely wrong with the business you bought. Start from the assumption that a stock is cheap for a reason and make the company prove otherwise. Sometimes the reason is that the market is distracted or impatient. Sometimes the reason is that the company is in trouble and the market noticed before you did.

So look for the same warning signs you'd notice in a household's finances. Debt that's large relative to what the business brings in is the classic one — a company that can't cover its obligations has problems that no valuation model fixes, and the price will keep reflecting them. A cheap price and a broken business look identical on a screener. Telling them apart is the work.

Market risk

Market risk is the risk of loss coming from the behavior of financial markets as a whole. No individual company controls it, and no amount of analysis on one company protects you from it.

It also changes how your work gets received. When the economy is expanding, investors extend companies the benefit of the doubt and take their projections at face value. When it's weak, the same investors get skeptical of the same numbers. Your case for a company can be identical in both environments and land completely differently.

Assumption risk

Here's the one that follows directly from the note at the top. Estimating intrinsic value means making a stack of assumptions about a company's future, and every one of them can be wrong. Be realistic about a company's prospects — a model built on hopeful inputs produces a hopeful answer that tells you nothing.

Opportunity risk

Opportunity risk is the chance that your money would have done better somewhere else. Every investment carries it, but patient value investing carries a particular version: your money can sit in a position for years while you wait for a repricing that hasn't come.

That's why an investment thesis — your written reason for owning something, and what would prove you wrong — is worth keeping and revisiting. New information arrives constantly, and it can strengthen your case or dismantle it. Valuing a company is a process you repeat, not a verdict you reach once and stop thinking about.

One thing that helps with all four: understanding why stocks get mispriced in the first place. Reading the broader economic cycle won't tell you what a company is worth, but it tells you what kind of mistake the market is likely making right now — and that makes your assumptions less of a guess.

Key takeaways

• Value investing compares a stock's price against your estimate of what the business is worth. Below your estimate is undervalued, above it is overvalued, and the bet is that price eventually moves toward value.
• Intrinsic value is an estimate you build, not a fact you look up. Two careful people can disagree about the same company, and the whole strategy depends on which of you is closer.
• Value and growth have traded leadership over long stretches, and neither wins permanently. A historical record shows an approach can work; it doesn't tell you what your years will look like.
• Value stocks have tended to swing less than growth stocks, largely because they tend to be established companies. Smoother is not the same as safer.
• Four risks are specific to this style: the company may actually be broken, the whole market may move against you, your assumptions may be wrong, and your money may sit idle for years waiting on a repricing that never arrives.