Wednesday, August 31, 2011

Core Concepts of Value investing for long term investors

There are many people who practice value investing in their own domains. The more value investors you will meet the more variety you will observe in their investing style. But the basics remains the same for all value investors. The core concepts of value investing remains same for all of them. In this article we will read about those core value investing which is essential to know for all long term investors.

As a ‘value investor’ you do not buy ‘shares’ you are buying a ‘business’ – Think like an entrepreneur

I know it is confusing but this is the step one of value investing. The strength of this step is so strong that if you can develop an aptitude like this you can be sure to succeed in investment of money. See what value investing ask you to do, it want you to think like an entrepreneur. Imagine yourself as wealthy and rich and then imagine that you are going to buy a business (yes you heard me right, total business).

Once you start thinking that you are buying a total business, the first question that will come to your mind is “How much this business is worth”. If somebody is quoting say $10 million for total business, then you must evaluate that whether this business is worth $10 million or less or more? In short you must know ‘true value’ of business.

This is the crux of value investing. Once you are thinking like an entrepreneur (with objective of buying total business) you are actually asking right investing question. Important is to know the true value of a business before buying it, value investors refer this true value as “Intrinsic Value”.

As a ‘value investor’ you do not buy business you heard-off, you buy business you know – Do your own research

Most of the value investors are so passionate about the business they are buying that almost seem to be in love with that company. Value investors a lot of time in reading annual reports, balance sheets, income statements, cash flow statements, directors reports etc of prospective companies.

They go really deep into analyzing companies based on their financial reports (balance sheets, income statements, cash flow statements). The idea is to unearth the ‘intrinsic value’ of a business. Let me tell you calculating intrinsic value is not easy, but if you have learned to read and comprehend financial statements estimating approximate intrinsic value will not be tough.

Calculating exact ‘true value’ of a company is not possible, but by thorough researching you can actually estimate a range (minimum and maximum) between which true value of business will lie.

Researching Balance Sheet will give you an idea of ‘minimum worth’ of a company:
By studying balance sheet you will get two important parameters that will help you to estimate the minimum levels of true value. If you compare this minimum true value with present market price of share, you will get an idea that how overvalued or undervalued this business is:

Net of Current Assets – These days you will hardly find a company trading at price levels equivalent to its net of current assets (current assets – current liability). But in times to come, if you find a good brand available at price levels like this you must grab it first leaving behind everything else. Suppose a company (Tata Steel) has net of current assets reported in its balance sheet as Rs 11,406 Cr. Number of shares outstanding in market is say 95.92 Cr numbers. Hence net of current asset per share will be Rs 118.9.

Net of Current Assets / ShareMarket Price / Share
Rs 118.9Rs 585

Let me give you a fact that even during the recession of year 2008, the price level of Tata Steel did not touched Rs 118 mark (the minimum was Rs 150 levels). The idea of knowing net assets value per share is to know that in times of liquidation, does company has enough finance (from current assets only) to pay back its shareholders.

Accumulated Reserves -  Suppose a company (Tata Steel) has accumulated earnings/ reserves of Rs 45,807 Cr. Number of shares outstanding in market is say 95.92 Cr numbers. accumulated earnings/ reserves per share = Rs 487. This share has current market price of Rs 585. Hence as compared to its Net worth per share, the share of Tata Steel is slightly overvalued.

Accumulated Reserves / ShareMarket Price / Share
Rs 477.5Rs 585

The idea to value of reserves to estimate true value is that in case of liquidation, company can sell these reserves to pay to the shareholders (who are proportional owners of the company). But if a share holder has bought a share at current market price of Rs 585, then he will be under loss.

But it is not fair to value a company only on basis of its reserves, in case of liquidation, the company can  also sell its assets to obtain more funds to pay back to its shareholders. In this case we must know the book value of the company.

Book Value – Another important parameter that is visible in balance sheet is book value. Book value can be calculated as Total Assets – Total Debts owed by the company. Suppose a company (Tata Steel) has total assets worth Rs 76,745 Cr and total debts /loans owed by company is Rs 29,801 Cr. Hence its book value will be Rs 76,745 – Rs 29,801 = Rs 46,944. Number of shares outstanding in market is say 95.92 Cr numbers. Its book value per share will be Rs 489.

Book Value / ShareMarket Price / Share
Rs 489Rs 585

As compared to its book value, the share is slightly overpriced.

Researching Income Statements will give you maximum worth of a company
Earning per share and PE Ratio – In the income statements (profit and loss accounts) investors can get valuable information in terms of earning capability of company.

In order to value a company in terms of its Earning Capability is not a direct method, instead we may have to do some assumptions. I have done some sample calculation of intrinsic value for some companies.

You can visit this link to get an idea (Intrinsic value calculation EPS/ PE Ratio)
Residual Income – True value of company can also be estimated from ‘Residual Income Method’.
Researching cash flow statements will give you an idea of max. worth of a company

Discounted cash flow analysis also gives a very idea of the maximum worth of a business.

As a ‘value investor’ you shall not concentrate on diversification of your investment – When you can buy gold at the price of silver why to invest in silver

As a true value investor, it will not be wrong if I say that diversification is not our cup of tea. Diversification is for those investors who are not confident about the future growth prospects of the company. But value investors does just that, 90% of time they invest in researching the true value of a company and once they obtain one, they buy it in big lots.

In similar circumstances, normal investors would not dare to buy such big lots of shares of one company as they do know the growing prospects of the company.

Value investors does two things very differently than other investors, one they do the fundamental analysis of company (obtaining true value) in much greater detail than others and secondly they never play stock market during bull phase.

When all other investors are singing ga-ga in stock market, value investors sit idle. The reason being, in bull market even ordinary companies are trading at prices much higher than their true value. Leave alone good company, in bull phase they will be trading at exorbitant prices. So if a value investors will not find a share trading below its true value, they would instead prefer to sit outside.

As most of the time value investors sit idle, they are doing few things which is important to note (1) In their free time they go on saving their cash so that the same can be used to buy value shares later, (2) They are identifying, researching and tracking good companies that they can buy when are available at discounted price levels.

As value investors are not compulsive investors, the partly loose the opportunity to compound their money. But when they buy they buy shares at extremely discounted levels and that makes up for compounding. Undervalued shares multiples very-very fast. As a rule of thumb, normal investors are investing most of the times in the market buy value investors stays idle more than 90% of their time.

Value investing is more common sense than an investing trick. Two basics of value investing as discussed in this article are (1) knowing to calculate the true value of company, & (2) Not investing in market when all others are investing (bull phase) are one of most logical principle of value investing. As value investors buy low (as compared to its true value) and hold the share forever they save a great deal of money on account of infrequent trading charges and taxes. As value investors always invest in a bulk, hence saving these charges and taxes are very important for them.
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