Techniques of Value Investing

Earlier, we learned the golden rules of value investing based on which let us discuss a few techniques of value investing. 

Value Investing is an arduous task that requires substantial efforts to be put in analysis of a company and its industry. The fundamentals of value investing are not complicated and can be employed by even unsophisticated investors to identify stocks that are a good buy and have a potential to generate substantial returns in the future. Some of these basic principles were identified by Benjamin Graham in his book ‘The Intelligent Investor’ back in the mid-1990s and several of these are relevant even in today’s time.

One of the key concepts introduced by Graham is the intrinsic value of a company or its stock. Intrinsic value in plain terms is the true value of a stock. The basic tenet of value investing is to determine this intrinsic value for a stock and then buy those that are trading at prices below their intrinsic value. By thorough analysis of the financials and business of a company, a value investor aims to uncover stocks that are undervalued with the belief that the market will eventually realise its value at a later point of time and the price will correct to a higher level.

Value investing entails several more criteria than the frequently recited phrase “Buy stocks that have a Price/Book-Value (P/B) ratio of less than 1”. It is important to club this factor with several other criteria to determine stocks that are not only cheap but are also backed by a financially sound company with strong business model. P/B ratio below 1 can very well correspond to a company that is financially weak and on the verge of failure. This is why an exhaustive analysis across multiple aspects is essential to get a holistic picture of the actual value of the company. There are also situations where certain criteria work better than others. E.g. P/B ratio is more relevant when analysing companies that are capital intensive but tends to be less effective in case of non-capital-intensive firms.

Rather than looking at the absolute values of certain ratios, comparing these ratios for a company to the ratios for similar companies in the industry often yields better results. This is especially relevant in case of valuation ratios such as Price/Earnings (P/E), Enterprise Value / EBITDA (EV/EBITDA) and Price to Book value (P/B). 

Another metric that Graham considered as one of the more accurate representations of a company’s worth was Net Current Asset Value (NCAV). It is a rough measure of the liquidation value of a company. A company’s liquidation value is estimated by subtracting the cash owed to the firm’s creditors from the cash that could be received if all the hard assets of the firm (excluding intangible assets) were sold and the business was closed. 

The technical formula for NCAV is: 

NCAV = Current Asset – Total Liabilities – Preferred Stock 

where, Current Assets = Debtors + Inventory + Cash & Cash Equivalents

Total Liabilities = Current Liabilities (Creditors) + Long term borrowings

Companies whose NCAV per share (NCAVPS) is below its share price can be used as one of the criteria to identify companies that are a good buy from the perspective of value investing. 

A downside of using such a measure is that these criteria are relatively skewed towards identifying companies that have been colloquially termed as cigarette butts. These are beaten down companies that are trading below their value of liquidation. While getting a share at a substantial discount to liquidation value might give decent returns in the short term, it is not a useful strategy from a long-term perspective. In a few cases, these cigarette butts might be firms that are real gems and have a strong revival potential. 

Discounted Cash Flow (DCF) Valuation

There are alternative methods to get an idea of the intrinsic value of a stock apart from those suggested by Ben Graham. One of the most popular methodologies is that of Discounted Cash Flow Valuation, commonly called DCF. 

The formulae that we need to know to perform DCF calculations are as follows:

FCFF = NOPAT + D&A – Capex – Change in Net Working Capital 

NOPAT (Net Operating Profit after Tax) = EBIT x (1-t)

Terminal Value = {FCF_n x (1+g)}/(WACC – g) 

Now, let us explain the concept of DCF using the example of a company listed on the stock exchange:  

Value of Time Warner (Total of PVCF) = $9924.14 million or $99.24 billion

Now, we calculate the per share value of Time Warner and compare it with the market price at which a single Time Warner share is trading in the stock market.  

Say, No. of outstanding shares = 10,000 million 

Market price of Time Warner = $100

Then, Value per share (refers to Intrinsic or true value here) = $99242.14/10,000 = $99.24 

Since true value is lesser than the current market price, the share is said to be overvalued. It is expected that in some time, the irrational investors will exit the market and the price will converge to its true value, thus falling down to $99.24. Thus, if we sell the share at $100, we will be making a profit when the stock falls down to its true value.