Value investing refers to a style of investing that involves buying assets such as stocks, bonds, real estate etc. at a price that is below their intrinsic value hoping to sell them at a higher price in the future. Value investors believe that an asset’s price, while it may fluctuate widely in the short-run, will move towards its intrinsic value in the long-run. Some value investors may also short assets that they believe are trading at a price that is higher than their intrinsic value hoping to make a profit when its price drops.
American economist and value investor Benjamin Graham, who is the author of the classic 1949 book The Intelligent Investor, is considered to be the father of value investing while American billionaire investor Warren Buffett is seen as a leading proponent of the value style of investing.
How it works
Value investing is based on the premise that the price of an asset can vary widely from its intrinsic value, which is the discounted value of the likely future cash flow from the asset. For example, the intrinsic value of a company’s stock may be 100 rupees per share, but it may be trading at a market price of only 60 rupees. This disparity between the price and the intrinsic value of an asset gives an opportunity for value investors to buy the asset at a price that is below its intrinsic value. Over time, as more investors begin to notice the gap between the price and the intrinsic value of the asset, the price of the asset is bid up towards its intrinsic value. This in turn allows value investors who bought the asset when it was underpriced to sell at a profit. So, a value investor who bought the stock of a company when it was undervalued at 60 rupees per share initially could potentially earn a profit of 40 rupees (or even more) as the price of the stock is bid up by other investors towards its intrinsic value of 100 rupees per share or higher. A value investor generally sells an asset once its price has exceeded its intrinsic value.
The philosophy of value investors differs from that of efficient market theorists who argue that the price at which an asset is traded in the market closely tracks its intrinsic value. Efficient market theorists believe that markets are so efficient that all information that is relevant to an asset is quickly reflected in its price, thus offering very little opportunity for value investors to purchase undervalued assets. In fact, many believe that value investing is dead today because markets price in information so quickly more often than not, which makes it hard to spot good buying opportunities in the modern market.
Value investors, on the other hand, believe that price and intrinsic value can differ for long periods of time, thus offering investors opportunities to make profits by buying assets below their intrinsic value.
Judging intrinsic value
The price of an asset may differ from its intrinsic value for various reasons. For one, estimates of the intrinsic value of an asset may vary depending on the opinions of investors. For example, if the majority of investors fail to expect a major rise in the future cash flow of a company, they may undervalue the company’s share and hence be willing to pay only a low price for it. This gives contrarian investors an opportunity to buy the asset at a cheap price, and sell it later when other investors finally recognise the enhanced earnings power of the company. It should be noted that since the estimation of the intrinsic value of an asset is an uncertain affair, value investors seeking a “margin of safety” generally look to invest only in opportunities where there is a significant disparity between the price and the value of an asset. The price and the intrinsic value of an asset can also vary during times of crisis when investors sell their assets in panic. So crises can offer value investors a great opportunity to buy undervalued assets. In fact, value investors believe that market panics are the best time to buy and booms the best time to sell.
Some investors differentiate value investing from growth investing, which primarily focuses on purchasing assets such as stocks that are expected to witness rapid earnings growth. Value investors, however, contend that even growth investing is based on the core value investing principle of exploiting the discrepancy between the price of an asset and its intrinsic value. They argue so because while growth investors might, for example, focus solely on investing in stocks with rapidly growing earnings, they still may not make profits if they pay for the stock a price that is far higher than its intrinsic value.
