Getting started on value investing
The term ‘value investing’ can often be mistaken to be an extremely boring or non-profitable way of buying stocks. Type ‘Is value investing dead?’ in your Google search bar and you’ll see tons of articles – some for and some against the statement, though a worrying number of people agree. In this article, I’ll show you what value investing truly means, and why it’s an important approach that can be used to guide your investment decisions.
Have you heard of Warren Buffett? If you haven’t, fret not. He’s a nobody – I mean, he’s only one of the richest beings in the entire world. Oh, he also happens to be Chief Executive Officer of Berkshire Hathaway, a company worth about 600 billion USD at the time of writing this article. Okay, maybe he’s somebody after all; I mean, people don’t call him ‘The World’s Greatest Investor’ for nothing. So, what’s his secret?
Here’s a brief three-point breakdown of Warren Buffet’s investing philosophy:
- Only invest in companies you understand
- Buy stocks at a price below intrinsic value
- The companies you invest in should have a good chance of being profitable in the long-term
If this appeals to you, there’s a good chance that value investing might be your thing. The listed principles are precisely what a prudent value investor follows when making investment decisions.
The process of value investing involves multiple stages of due diligence – not just for the company’s prospects, but also for its valuation. It’s a process that is known to be profitable in the long run, but it’s pretty hard to get right.
Value investing requires a significant amount of discipline, with facts taking precedence over emotions. It also demands patience, as you won’t be doubling your money in a few days like that friend of yours who bought AMC shares.
It’s a systematic approach that looks easy to follow, but many stumble and some even give up altogether. I’m here to make this as easy as possible to understand, and also to show you why value investing is here to stay. Let’s get started!
Step 1: The initial screening
Before you invest in a company, there are a few questions you need to ask yourself – and you need to be as honest as possible.
What does this company do, and how exactly does it make money?
Yes, you need to know exactly what the company is about. For a start, it’s good to be familiar with the company’s operations and revenue-generating services.
Is the company in question facing direct competition from other companies? If so, which ones?
It’s important to know what and who the company is up against. We’ll explore a little later on how we decide who’s best.
Do you have faith in the industry in which the company is operating?
Think about the industry in general. Is it here to stay in the long-term?
When the answers to these questions are clear to you, and you still believe that this company is worth considering, we can move on to the next step.
Step 2: A deeper dive
Now that you’re sure that you understand the company, we’ll see how the company has been doing. This can be done in various ways, including but not limited to:
- Looking at trends of important financial metrics (revenue, free cash flow, net income, etc.); gives you an idea of the trajectory which the company is on, and paints a better picture of how the company has been doing financially.
- Keeping track of company activities (M&A, issuing or buying back of shares, product performance, R&D, dividends, etc.); reveals a lot about the company’s developments, business strategy, and management.
- Reading recent earnings reports and looking out for important things like YoY growth, product developments, and future guidance; tells you exactly how the company is performing at the current moment and also gives you a better idea of its future.
Now, this can be quite tedious to do – and it’s supposed to be. Being a good value investor isn’t supposed to be easy, and requires quite a bit of effort on your end. Take the time to understand the company’s activities and numbers. If they resonate with you, we can proceed.
Step 3: Valuation
Here comes the tricky part – what’s the company stock price worth today? Nobody has the exact answer for this, but we have a few useful tools which can help to give us a rough estimate of what the company should be valued at given its current performance and future projections – otherwise known as its intrinsic value.
We call these tools ‘valuation methods’. Here are some you can consider using!
Discounted cash flow (DCF) model
The DCF model is commonly used by experienced value investors to estimate the intrinsic value of a company based on its cash flows. To be specific, the DCF Model calculates the present value of the company’s projected cash flows. Sounds daunting, doesn’t it? But fret not, we’re here to help you out. Here are some resources which can help you fully understand and implement this model.
- A read-up on the time value of money: This is important as the DCF Model abides by the concept of the time value of money.
- DCF Guide: This is a concise guide on how to use the DCF Model.
- Hands-on DCF Example: This is a video of a YouTuber analyzing a company and its valuation with the DCF Model.
Comparable companies analysis (CCA/comps) model
The Comps Model is used to determine the intrinsic value of a company relative to its competitors. Deep fundamental analysis is done on the company and its closest competitors, and meaningful data like P/E, P/B, EV/EBITDA, etc. are obtained and consolidated so that the investor can see if his or her choice is truly the best deal. Greek to you? No worries. We’ll help you out with some resources.
- Comps Guide: This is a concise guide on how to use the CCA/Comps model.
- Hands-on Comps Example: This is a video of a YouTuber analyzing a company and its valuation with the Comps Model.
Earnings-per-share projection (EPS projection) model
The EPS Projection model is a method of calculating the intrinsic value of a stock based on its earnings-per-share projections. This is also a common method used by investors, especially when forecasted EPS numbers are readily available. Here’s how you can do it.
- Hands-on EPS Projection Example: This is a video of a YouTuber analyzing a company and its valuation with the EPS Projection Model.
Step 4: Investment Decision
Now that you’ve done the dirty work, the last question remains: Is the stock a buy at its current value? If your valuation methods indicate that this is not the case, you must follow through with that conclusion.
Remember that value investing is a systematic process that should not be influenced by impulse and emotion. If you thought it was a buy, but your findings suggest otherwise, be patient and wait till the stock falls to your desired price point. You may also implement some simple options strategies like selling puts, which are covered in another article we have on our platform.
If your price target indicates that the stock is a Buy, perhaps it may be a good time to start a position.
However, one must take note that whatever output you obtain from your value investing procedures is completely dependent on your accuracy of the information, reliability of forecast, and personal judgment.
As such, just like any other investment method, value investing is not a sure-win strategy. It is, however, an excellent way for you to reduce risk by exercising objective judgment and carrying out financial analysis on the companies you’re interested in.
Other Resources
As you begin on your value investing journey, you’re likely going to run into a few obstacles. However, there’s no need to worry! Whether it’s obtaining reliable financial data, finding up-to-date financial news, or searching for useful stock screeners, our platform has everything you need to guide you through your investing journey.
Let’s try an example!
Just so you completely know what we’re talking about, I’ve decided to show you a brief breakdown of my value investing process. Let’s use Meta Platforms (NASDAQ: META) as an example.
Step 1: The initial screening for Meta
How does Meta earn money?
We know that Meta Platforms generate substantial revenue from advertisements on social platforms. To be specific, Meta owns Whatsapp, Instagram, and Facebook.
How does Meta compare to its competitors?
As Meta has access to that many users, there’s a good chance it’ll have a huge advantage over many of its competitors. However, in recent times, TikTok has been proven to be a formidable industry rival, having forced Meta’s hand to introduce Reels to remain competitive.
How relevant will the industry that Meta operates in be in the future?
Social media and advertising are here to stay, and there’s a good chance that Meta Platforms can thrive and stay relevant even in changing times.
Step 2: A deeper dive
What are Meta’s financials?
We can use tools like MarketWatch and Yahoo Finance to obtain the relevant metrics we need to analyze the company’s financial performance.
We can see that revenue and free cash flows have been on a steady rise. Net income and earnings-per-share also have been on a general upward trend. We also see that shares outstanding are going down, which is good news for investors who are now each owning a bigger piece of the pie.
While I won’t go into complete detail, it’s good that we mark out a few key metrics to look out for whenever we analyze a company’s financials. Apart from the above-mentioned, we can also evaluate a company’s LTD to FCF (Long-term debt to free cash flow) to determine how financially capable a company is when it comes to paying off its long-term debt.
In the case of Meta, the ratio is less than 1, which indicates that the company’s free cash flows are more than able to pay off the long-term debt, which is always a good thing. From what I’ve seen, I do believe that Meta’s financials are decent.
What’s Meta doing right now?
Meta has announced this year that it would be investing a whopping $10b into the metaverse! Yes, you heard that right. The company is putting a very substantial bet on the metaverse being the future and is already in the development stage for such products and services. Now, is this necessarily a good or bad thing? It’s not definite, but this will be taken into consideration when we conduct our value analysis.
How has Meta done this year?
To answer this question, we can go ahead and search for articles about Meta’s recent earnings, or head to Meta’s investor relations to obtain the most recent reports of the company.
As shown above, Meta has failed to meet analyst expectations in Q1 2022, so this is mildly concerning. Many are concerned that Meta’s growth rate is slowing down due to intense competition. We’ll have to keep this in mind.
Step 3: Valuation
Now that we’ve taken a more thorough look at the company, how should we evaluate its intrinsic value? I have decided to use an EPS projection model for this example.
I will set my metrics according to my assumptions for Meta. In this example, I’ll be going with a 10% growth in earnings, no increase in shares outstanding, and a projected P/E of 20. I’ve also tagged on a margin of safety of 25% and found the weighted average cost of capital (WACC), which turned out to be about 9%
.
Now, I didn’t just come up with these numbers randomly. They were based on an analysis of the company’s past financials, and also after taking into account the possible concerns for the future (like the uncertainty brought about by investment in the metaverse, slowing growth rates, competitors, etc.).
Since Meta has done about 25% average annual growth in earnings for the past 5 years, I am going to be conservative and project a 10% growth for the next 5 years. As for the shares outstanding, since Meta has had an excellent track record of buying back shares, I’m going conservative, again, and assuming that there wouldn’t be any change in shares outstanding in the next 5 years. I also tagged on a 25% margin of safety in case my assumptions don’t play out in the way I expect them to.
Of course, each person has his or her assumptions, and reasons for making them. As such, there isn’t a wrong answer when it comes to setting these metrics. We investors just have to live with the consequences if we end up exercising poor judgment.
As for things a little more technical like the WACC, the resources I’ve listed do show you how to obtain this number. However, there are also online tools like the Calkoo WACC Calculator to make your life a little easier.
We see that we’ve arrived at a price target of about $184. The stock currently trades at about $159, so it’s a bargain. Also, if you’re wondering how I started with an EPS of 11.74 for year 0, I’ve taken year 0 to be 2022 and used the average analyst-estimated EPS for that year, which happened to be 11.74.
Step 4: Investment Decision
Considering that my assumptions were so conservative, I would be inclined to start selling puts or initiate a small position. However, there’s no hard and fast rule. Everyone has his or her risk tolerance, and while it’s easy to be inspired by analyses conducted by others, you need to know how to follow this system on your own.
Conclusion
Now, that was just a brief example of how value investing is done! I didn’t go too much into detail, as this isn’t an article about Meta. However, when you do this alone, be as thorough and diligent as you can. Remember, it’s your money. Follow the process and make a sound decision based on your due diligence and evaluation.
Hope this little guide I put together manages to find and help many souls who are interested in value investing!
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