The Science and Art of Value Investing

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This blog provides a thorough examination of value investing, including many approaches.

The plot

There are other ways to invest in the stock market, and the one we’ll discuss has regularly produced positive results for those who have followed it correctly. Benjamin Graham, the father of value investing, Warren Buffet, the world’s third-richest man and arguably the most successful investor of all time, Peter Lynch, Rakesh Jhunjhunwala, Ramesh Damani, and Ramdeo Agrawal have all used value investing in building their fortunes and promoting it as a path to financial freedom. Let us delve deeper into investing and learn what “value investing” is and how it works. Warren Buffet once said, “Investing is simple, but not easy.”

Let us first define the difference between price and value before moving on to value investing. Isn’t it obvious what the price is? “It’s what we pay when we buy something,” says the author. However, the concept of value is a little more nuanced, as “it is the true worth or use of everything we buy,” but it can differ from the actual market price in some ways. The price of a commodity is determined by demand and supply, and it fluctuates over time, whereas the value remains constant.

Similarly, a company’s stock price fluctuates daily, but its worth remains stable because it is based on its financial soundness and future growth prospects rather than the demand-supply metric; we call this the intrinsic value of a stock (death stock). If the price is more than the inherent value, we call it “overvalued,” and if it is lower, we call it “undervalued.” If the price is the same as the market price, we call it “at par.”

What is the definition of value investing, and how does it work?

The value investing philosophy instructs us to acquire fundamentally solid firms that are now undervalued, with the expectation that their share price would eventually catch up to their intrinsic value if the company is financially sound. A company’s financial stability means it shouldn’t have too much debt and should have positive cash flows; if money comes in regularly, it can continue its daily activities. 

Later, when the price is high, we can sell them to make a profit. Isn’t it a simple concept? “Buy low, sell high” is a simple notion, but it is challenging to implement because the tools and strategies are sophisticated, and a thorough grasp of the business is also required. The intrinsic value of a stock can be calculated using DCF, Dividend Discount Model, and Growth Model. Psychological components such as discipline and patience are equally vital because we talk about ten-year or longer investments. Let’s dissect both elements and examine them in-depth.

The concept of free cash flow and DCF

Before we begin, prepare to chew some vegetables, as we will discuss all of the complex but critical principles of value investing and the science behind them in this section.

To begin, let us define the concept of free cash flow. The money flows freely into the business after all expenses have been paid, and it is what the company receives. As a result, having healthy cash flows becomes critical.

EBIT stands for earnings before interest and taxes, and it refers to a company’s profits after all expenses have been paid, excluding interest and surcharges.

NOPAT stands for “net operating profit after tax,” as we have deducted tax from EBIT.

Depreciation is a drop in the value of an asset over time that is deducted while calculating profit, but we add it back because it is a non-cash expense with no cash outflow.

Capital Expenditure: – Funds needed to expand the business must be set aside, which is why it is deducted from operating profit.

Working capital is the amount of money required for day-to-day activities.

Cash flow discounted

It indicates the present value of all future cash flows, often known as a stock’s intrinsic value. Now you may be wondering how we can forecast the future. Cash flows are determined by revenue, cost, tax rates, and investments and require a thorough grasp of the business to predict what the company will receive in the future. As a result, it becomes subjective and depends on your attitude toward a corporation.

We discount all cash flows at their present value (NPV), but who determines the discount rate? The cost of capital “Equity and Debt” determine it, and we use a weighted average to arrive at a percentage, which we then discount. Discounting is the polar opposite of compound interest computation.

The discount rate in the net present value computation is WACC, which stands for “weighted average cost of capital.”

NPV – The net present value is the current value of all future cash inflows, and comparing it to the market value of a share can help you decide whether to Buy, Sell, or Hold.

A Safety Margin

We all know that the future is unpredictably unpredictable and that the art of valuation does not ensure success. As humans, we all make mistakes, and we must maintain a safety margin to avoid potential loss. For example, in a juice business, a shopkeeper may know that the daily sugar requirement is 5 kg, but he keeps 10 kilograms of sugar in stock to ensure that he can meet demand in a shortage. 

Similarly, we must maintain a safety margin. For example, if Wipro’s current price is 355 and your valuation says the price should be 380, you shouldn’t buy it only because it’s a cheap company because every calculation has a margin of error. If your valuation is 500, the small margin of error can be overlooked because if it does not reach 500, it must at least call 480. Furthermore, individuals’ risk-bearing capacity and personal preferences influence the margin of safety; most investors feel a 2/3 buffer to be enough.

Mind Games

Now that we’ve eaten our vegetables, it’s time to play some mental games. You might be wondering why everyone isn’t an intelligent investor and only buys firms that are “obviously” undervalued. We’ve put up a list of psychological roadblocks to value investing.

– Optimism Remember how important it is to have a thorough understanding of a firm and its operations. Understanding a business ideas is a “Tight-rope walk,” The more you learn about it, the more hopeful you get about it. Furthermore, a profound grasp of the business is essential. Therefore you must become self-critical to arrive at an accurate company valuation.

Criteria: – It’s critical to wait for a company that meets your standards because you might not find one for a long time, and all you have to do is wait or adjust your criteria, like a tiger who remains for a fawn and leaps at the right moment.

Nerve: – Now that you’ve purchased the firm and are witnessing market ups and downs, you’ll notice that your heartbeat is synchronised with your company’s share price. Well! Yes, you might have a heart attack in that circumstance! In the long run, markets shift as Bull and Bear faze come and go, but you must feel that what you have purchased is correct and will reach the destination you expect.

Discipline: – An investor must be extremely clear in his mind that he only buys inexpensive stocks; otherwise, he can get carried away with market news and what others are buying and wind up buying garbage stocks. So, if you’ve chosen one or a few stores, you should remain with them.

Conclusion

You may have heard that investing in stocks is similar to gambling, but this is not true. Although it cannot guarantee results, it is a tried and true method based on facts and figures. You must first understand how to evaluate a firm before proceeding; the only complication is that it is highly subjective and demands a solid intellect perform. The formula must be easy, and the statistics must tell a story to verify your cash flow forecasts, as this will determine how much the company is worth.

Points to Consider

  • Use the proper technique.
  • Take your time estimating cash flows, and remember that every number must answer the question “why.”
  • Follow your estimates and judgement rather than the herds.
  • Always keep a safety margin in mind.
  • Should avoid short-term market swings, media headlines, and other market hypes.
  • Have patient and be disciplined.
  • Finally, a reliable firm will generate money because share prices follow real value, so be sure the company is profitable and has room for future expansion.

“The key to investing is to figure out what something is worth and then pay a lot less for it.” Greenblatt, Joel

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