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23 July 2024 10h10

Value investing: what it is, what is its purpose and limitations

Value investing: what it is, what is its purpose and limitations

 

Find out what value investing is, what it’s for and how it works in practice.

 

Knowing when stocks are undervalued (i.e. trading below their true value) is a challenge for even the most experienced investors. This is where value investing comes into play, a strategy favoured by Warren Buffett, Benjamin Graham, Charlie Munger and many other famous investors. Find out what it means, what its purpose is, and how to put it into practice.

 

 

What is value investing?

 

Value investing is an investment strategy that focuses on selecting stocks that are trading below their intrinsic value. Intrinsic value, in turn, is "the discounted value of the cash flows that a company can generate over its remaining useful life”, as defined by Warren Buffett.

 

Investments are therefore made on the basis of an analysis that allows the potential of a stock to be deduced, rather than the value defined by the current capital market price.

 

 

The benefits of value investing

 

These are the main benefits of value investing:

 

1. Long-term growth potential: Value investing focuses on investing in assets that are undervalued relative to their intrinsic value. By identifying and acquiring these assets, investors can benefit from the potential for returns over the long-term as the market recognises the true value of these assets.

 

2. Focus on data: Value investing emphasises the fundamental analysis of companies, including their income statements and cash flows. To follow this method, investors must truly understand the financial health and growth potential of the companies in which they invest.

 

3. Resistance to market volatility: By taking a long-term, focused approach to financial analysis, investors tend to be less affected by the short-term market volatility. This allows them to remain calm and disciplined during periods of turbulence, avoiding knee-jerk emotional reactions.

 

 

What are the limitations of value investing?

 

Value investing is a strategy that requires patience and financial knowledge. Undervalued stocks worth investing in are difficult to identify, often even for experienced professionals. Estimating the intrinsic value of a company's shares requires a high level of expertise and depends on factors beyond the traditional investor’s control – for example, changes in management, the emergence of new technologies and the behaviour of competitors. Even if you analyse all the fundamentals, there's no guarantee you’ll make the right call.

 

 

How do you implement a value investing strategy?

 

A long-term value investing strategy must follow these steps in order to be successful:

 

1. Estimate the free cash flows

Once you have made a shortlist of companies, estimate the cash flows that each company can generate over a projection period (for example, over the next 10 years). Cash flow is the amount of money the company can release over this period. For many investors, this measure represents the true financial health of a company as it takes into account revenues, costs, working capital management, capital expenditure and other operating and investing activities.

 

The analysis of the companies’ activity reports will be of added value as they contain relevant data for the construction of these estimates of cash flows generated.

 

2. Determine the discount rate

The discounted cash flow method involves projecting an entity’s expected future cash flows and then discounting them back to the present using an appropriate discount rate.

This discount rate generally reflects an average of several factors, such as:

 

· the company’s cost of capital;

· the minimum return investors demand for the risk they are taking;

· the risk-free market rate of interest;

· the profitability of alternative investments.

 

3. Calculate current intrinsic value

Future money is worth less than present money because of the time that has passed and the risk involved. To calculate how much the intrinsic value is worth today, the chosen discount rate is applied to the expected cash flows in each year. The discounted cash flows are then added together to give the present value of the investment. This value represents the estimated intrinsic value of the business or project.

 

4. Consider qualitative factors

In addition to this method, you should also consider qualitative aspects of the company, such as: quality of management, competitive advantages, secular growth prospects in the industry, regulatory issues, and sustainability issues. By doing so, you’ll be better prepared to validate or refute the purchase decision based on numbers alone.

 

5. Make the purchase decision

Once you have calculated the net present value using the discounted cash flow method, you still need to make the final purchase decision. To do this, compare the net present value with the current market price of the company or asset in question. If the intrinsic value is higher than the market price, this indicates that the asset is undervalued and could be a buying opportunity. Conversely, if the current intrinsic value is lower than the market price, this indicates that the asset is overvalued and may not be a good buy.

 

It is also important to consider a margin of safety when deciding whether to buy. In other words, even if the intrinsic value is slightly higher than the market price, it may be prudent to buy only if there is a comfortable margin between the calculation value and the current price in order to mitigate risk.

 

To better understand how this strategy works, imagine that you are valuing a company that expects to generate the following cash flows over the next five years:

 

- Year 1: €100,000

- Year 2: €120,000

- Year 3: €150,000

- Year 4: €180,000

- Year 5: €200,000

 

Let’s also assume that we choose a discount rate of 10% per annum to reflect the company’s cost of capital or the minimum return expected by investors. For each year, let's calculate the present value of the cash flow using the formula:

 

- Year 1: 100,000 / (1+0.10)^1=90,909

- Year 2: 120,000 / (1+0.10)^2=99,173

- Year 3: 150,000 / (1+0.10)^3=115,737

- Year 4: 180,000 / (1+0.10)^4=123,967

- Year 5: 200,000 / (1+0.10)^5=124,629

 

It is now expected that the company will continue to operate beyond year 5, but as this is a longer horizon, there is less visibility on the evolution of cash flows, so we try to determine the terminal value of the company. This value is the present value of the cash flows from year 5 onwards. For the sake of simplicity, assuming that the cash flows grow by 3% each year, the terminal value in year 6 is given by the formula:

 

- Year 6: Terminal value [200,000 * (1+0.03)/(0.10-0.03)]/(1+0.10)^6 = 1,661,166

 

Therefore, the present value of the expected cash flows over the next five years is €554,415. This value added to the terminal value represents the intrinsic value of the company today, based on the expected future cash flows and the chosen discount rate. If the current market price of the company is less than €2,215,581, this would indicate that the company is undervalued and could be a buying opportunity according to the value investing approach.

 

However, it is important to emphasise that this illustrative example has been simplified to provide a very brief description of the general principles of company valuation, a process which is not limited to this level of detail.

 

6. Seek specialist advice

Seek advice from investment specialists, such as those at Banco Carregosa, who have the expertise to identify value investment opportunities. If you wish, you can delegate your investments by using management models with a value investment policy. In this way, you know that your investments follow this investment philosophy, but you leave the choice of securities to the professionals in the field.

 

Talk to your financial advisors regularly to adjust your investment strategy in line with market changes and your own financial circumstances. Use the resources on our website, such as articles and research reports, to update your knowledge of value investing and make more informed investment decisions.

 

Alternatives to value investing

In addition to value investing, there are other methods that can be used to boost the growth of your assets.

 

Growth investing

Growth investing is an alternative approach to value investing that focuses on companies with a history of rapid growth in terms of profits, sales and/or cash flow. This strategy focuses on the capital appreciation potential of each investment, with a long-term perspective. Risks associated with this approach include uncertainty about the future and market instability, which may result in substantial financial losses.

 

Invest in dividend-paying stocks

This strategy focuses on companies that pay out part of their profits to shareholders in the form of dividends. It is an attractive investment for those seeking a steady return over time. Before adopting this strategy, it’s important to select companies with a solid track record of cash flow and profit distribution to shareholders.

 

As a preliminary analysis, it is useful to consider the dividend yield, which is the ratio between the dividend paid and the current share price, usually expressed as a percentage. For example, if a share worth €100 pays a dividend of €5, the dividend yield is 5%. This indicator helps to compare dividend opportunities between companies in the same sector.

 

It is also important to assess the payout ratio, which is the percentage of profits that a company pays out as dividends. This assessment is important in determining whether or not the company’s remuneration policy is attractive to investors.

 

 

Banco Carregosa, a sound way to build up your assets

Investment security is essential for building a financial future. At Banco Carregosa, you can benefit from the knowledge and experience of our financial experts and receive personalised advice on how to invest wisely.