Value Investing

Value investing is an investment style that seeks to buy securities for less than an estimate of what they are really worth, their intrinsic value. Value investors study a company's assets, earnings, cash flow and debts, estimate a fair value, and buy only when the market price is well below it. They expect the price to rise toward that value over time as other investors recognise it.

The approach was set out by Benjamin Graham and David Dodd at Columbia University in the 1930s and is most closely associated today with Warren Buffett. It is usually contrasted with growth investing, which pays up for fast-growing companies. The shares value investors favour are called value stocks, and funds following the approach are classed as value-style funds.

Think of a bargain hunter at an estate sale who knows antiques. Most buyers judge a dusty cabinet by how it looks today. The expert checks the wood, the joints and the maker's mark, works out what it would fetch after cleaning, and buys only if the asking price is far below that figure. The gap between price and worth is the reason to buy, and the cushion if the estimate turns out a little optimistic.

Value investors do the same with companies. They ignore the mood of the market, which can push prices far too high or too low, and ask a simple question: is this business worth a lot more than what I am being asked to pay for it?

Benjamin Graham and David Dodd published Security Analysis in 1934, after the stock market crash of 1929 and the Great Depression had shown how far prices could stray from business reality. The book argued for careful analysis of financial statements and a sharp distinction between investment and speculation. Graham's later book for general readers, The Intelligent Investor (1949), introduced two lasting ideas: "Mr. Market", an imaginary partner who offers each day to buy or sell at prices driven by mood, and the "margin of safety", the discount to intrinsic value that protects the buyer against error.

Warren Buffett studied under Graham at Columbia, worked at Graham's firm and went on to run Berkshire Hathaway from 1965. Influenced by his partner Charlie Munger and by Philip Fisher, Buffett shifted from Graham's very cheap, often mediocre companies toward "wonderful companies at a fair price", businesses with durable competitive advantages bought below their long-run worth. His annual letters to Berkshire shareholders remain a standard text on the approach.

Value investors use several ratios to find candidates and then do deeper valuation work, such as discounting expected cash flows:

• Price-to-earnings. A low price-to-earnings ratio relative to the market or the company's own history.
• Price-to-book. A low price-to-book ratio, comparing the share price with the accounting value of net assets.
• Dividend yield. A high dividend yield, which can signal a cheap share (or a troubled one).
• Balance-sheet strength. Modest debt and enough cash to survive a downturn, so the company lasts long enough for value to be recognised.

The margin of safety is often expressed as a percentage of intrinsic value:

• $V$ is the investor's estimate of intrinsic value per share.
• $P$ is the current market price per share.

If an analyst values a company at $50 a share and it trades at $35, the margin of safety is $(50 - 35) \div 50 = 30\%$. Graham suggested demanding a substantial margin, so that even a sizeable error in the estimate would still leave the buyer whole.

Research by Eugene Fama and Kenneth French, published in 1992 and 1993, found that US shares with high book-to-market ratios (cheap relative to book value) had earned higher average returns than expensive shares over several decades, a pattern called the value premium. It became one of the factors in their three-factor model. Since about 2007, however, value indices have trailed growth indices for long stretches, especially during the technology-led bull market of the 2010s, prompting debate over whether book value still captures the worth of companies built on software, brands and data.

Other criticisms are practical. A stock can be cheap because the business is in permanent decline, a situation known as a value trap. Estimates of intrinsic value depend on assumptions about growth and discount rates, so two careful analysts can disagree widely. And patience is required: a cheap share can stay cheap for years, testing an investor's time horizon. Many investors therefore blend value with other styles as part of diversification.

• Berkshire Hathaway: Shareholder Letters
• Kenneth R. French Data Library (Tuck School of Business, Dartmouth)