Value investing is one of the best known stock-picking methods. The concept is simple: find companies trading below their inherent worth.
Benjamin Graham is considered the first proponent of value investing . He assumed that two values are attached to a company. The first is the market price, the value of the company on the stock exchange. The second is a company’s business value.
Business value or intrinsic value is based on its ‘real time’ value in the event of a merger with a competitor or in a takeover situation. Alternatively the owners may consider the business value as the amount that could be achieved by breaking up the company and selling all its assets.
The value investor looks for bargain price stocks: stocks selling at a low price but with strong fundamentals - including earnings, dividends, book value, and cash flow. Companies that are undervalued by the market have the potential to increase in share price when the market corrects itself.
Value investing doesn't mean just buying any stock that declines and therefore seems "cheap" in price. Value investors have to do their homework and be confident that they are picking a company that is cheap given its high quality. It's important to distinguish the difference between a value company and a company that simply has a declining price. For example, in the past year Company A has been trading at about $25 per share but suddenly drops to $10 per share. This does not automatically mean that the company is selling at a bargain. All we know is that the company is less expensive now than it was last year. The drop in price could be a result of the market responding to a fundamental problem in the company. To be a real bargain, this company must have fundamentals healthy enough to imply it is worth more than $10 - value investing always compares current share price to intrinsic value not to historic share prices.
One of the greatest investors of all time, Warren Buffett, has proven that value investing can work: his value strategy took the stock of Berkshire Hathaway, his holding company, from $12 a share in 1967 to $70,900 in 2002. The company beat the S&P 500's performance by about 13.02% on average annually! Although Buffett does not strictly categorize himself as a value investor, many of his most successful investments were made on the basis of value investing principles.
We should emphasize that the value investing mentality sees a stock as the vehicle by which a person becomes an owner of a company - to a value investor profits are made by investing in quality companies, not by trading. Because their method is about determining the worth of the underlying asset, value investors pay no mind to the external factors affecting a company, such as market volatility or day-to-day price fluctuations. These factors are not inherent to the company, and therefore are not seen to have any effect on the value of the business. In the long run, stock prices will reflect this business value, but in the short and medium term, market prices are often far above or below it.