Value Investing: how it works

One of the techniques to invest in the most profitable stocks in history is Value Investing. This technique was developed by Benjamin Graham and David Dodd in 1928 and has generated truly extraordinary results.

An example? The famous Warren Buffett, one of the richest men in the world, managed to accumulate his immense fortune starting from scratch by applying the principles of Value Investing to the letter.

In this article we explain in detail what Value Investing is, how it can be applied today and what are the limits of this technique.

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What is Value Investing, in simple words

Investing in Stocks is not complicated: unfortunately, however, there are many false gurus interested in selling low value courses that confuse beginners, presenting the stock market as a difficult market, to be dominated with arcane techniques. Obviously, these techniques are known only to them and for this reason they sell them at a high price.

In fact, we can say that there are two types of techniques for investing in the stock market:

1. Value Investing
2. Growth Investing

Value Investing is based on the principle that companies must be evaluated based on their tangible value and current earnings. In this case much less importance is attached to the market trend and future forecasts. These elements, on the other hand, are the basis of Growth Investing.

The basis of Value Investing is the idea that investing in shares is a real business: shares must be carefully evaluated, bought at a low price and then resold at a higher price.

In practice, doing Value Investing means trying to be immune from the irrationality of the market: you have to buy (with care and attention) when the market goes down and sell (always with care and attention) when the market goes up.

The fact is that markets are often driven by irrational elements. When Panic Selling occurs and everyone sells, for example, it’s time to buy. When everyone is buying stocks, it’s time to sell.

How to evaluate Stocks

Put like that, it seems to be simple and indeed it is. How do you decide if a stock has a low enough price? The inventor of Value Investing, Benjamin Graham, has developed a mathematical formula to calculate the value of a share:

√ (22,5 * Profit * Book Value)

If the price of a stock is lower than Graham’s number, then the stock is undervalued and worth buying.

These are easy calculations to do, since the data of listed companies is public. In any case, we must add that Warren Buffett, apostle of Value Investing, uses an even easier approach, of a qualitative rather than a quantitative type (we will see this later).

What do you need to do Value Investing

The principle behind Value Investing is all in all very simple: buy shares when prices are low and resell them when prices are high, making a good profit.

The value of the shares, this is an important point, must be calculated objectively, not with subjective illusions such as the market trend or the expectation of future profits. Among other things, expectations of future profits are always inflated to excess. Only current earnings are objective.

If the concepts behind Value Investing are so simple, why do so many investors fail when they try to apply the technique?

Failure is usually not technical but psychological: following the principles of Value Investing means buying when the price of a share falls and keeping it even if the price continues to plummet (always if the assumptions that pushed us to purchase are still true).

In short, if I bought a stock because it is convenient according to Graham’s number, I must not be frightened by a market crash. Unfortunately, many investors have an unlimited fear of losing money and therefore sell if a crash occurs.

The smart investor (according to Benjamin Graham’s definition), as we have said, buys during the collapses.

Here, what many lack to be smart investors and be successful with Value Investing is control of emotions.

Book to learn Value Investing

What is the best book for learning Value Investing? Many would rightly answer this question by Benjamin Graham’s The Intelligent Investor. In this book (from 1949) Graham exposes his theories to the general public.

Obviously, this is an outdated book (although periodically updated editions are published, the latest in July 2020) and with a rather substantial theoretical framework that could discourage novice investors who want to start investing without errors.

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This is the best way to start investing, also because a demo platform is available for free that allows you to invest virtual money: in this way you can do experiments without risking anything.

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Conclusions

Value Investing represents one of the smartest and most profitable approaches to the market. Long-term studies have shown that the returns that can be obtained are higher than those generated with other approaches (for example Growth Investing).

Those who follow Value Investing techniques decide whether to buy (or sell) not on the basis of market trends or forecasts of future profits but on the basis of concrete and measurable values such as net profit and book value.