Value investing basics. Graham and Buffett honestly.

Value investing buys stocks trading below their intrinsic value and holds for the long term. The approach was developed by Benjamin Graham in the 1930s, codified in his books Security Analysis (1934) and The Intelligent Investor (1949), and refined by his most famous student, Warren Buffett. The framework has produced more billionaires than any other investing style.

The honest version is mostly about patience and discipline. The mechanics are simple. The execution requires holding through periods (sometimes years) when value underperforms while waiting for the market to recognize the underlying business value.

The core thesis

The market consists of two participants. The first is Mr. Market, Graham's metaphor for the daily market price. Mr. Market is moody. Some days he is euphoric and offers to buy your stock at high prices. Other days he is depressed and offers to sell you stock at low prices. The value investor is not at Mr. Market's mercy. They use Mr. Market when convenient (selling when he is euphoric, buying when he is depressed) and ignore him otherwise.

The second participant is the underlying business. The business has real assets, real cash flows, real earnings, real growth prospects. The business value is what Graham called intrinsic value. The market price oscillates around intrinsic value, sometimes above and sometimes below.

Value investing buys when market price is meaningfully below intrinsic value and sells (or holds) when market price approaches or exceeds it.

What intrinsic value is

Intrinsic value is the estimated true worth of a business based on its fundamentals. Methods to estimate it include.

Discounted cash flow (DCF).

Project future free cash flows. Discount back to present value using a required rate of return. Sum the discounted cash flows to estimate present value. Time consuming but theoretically rigorous.

Earnings power valuation.

Estimate the sustainable normalized earnings power of the business. Apply a multiple based on growth prospects and quality. Simpler than DCF but requires judgment on the right multiple.

Asset based valuation.

Sum the values of all the assets minus liabilities. Useful for companies with substantial tangible assets. Less useful for asset light businesses (software, services).

Comparable company multiples.

Compare the target company's metrics (P/E, EV/EBITDA, P/B) to similar companies. Adjust for differences in quality and growth. Quick but only as good as the comparison group.

The estimate is always approximate. The value investor accepts this and builds in a margin of safety to protect against estimation error.

The margin of safety

Margin of safety is the gap between intrinsic value and purchase price. Graham recommended buying at 50 to 67 percent of intrinsic value, providing a 33 to 50 percent margin.

The margin protects against two risks. The intrinsic value estimate could be wrong (the business is worth less than calculated). The business could deteriorate after purchase (earnings decline, competitive position weakens). The margin absorbs reasonable amounts of both.

A stock with intrinsic value estimated at $100 should be bought at $50 to $67. Buying at $80 with a 20 percent margin provides less protection. Buying at $100 with no margin assumes perfect estimation and stable business, which is rarely the case.

The metrics value investors watch

Price to earnings (P/E) ratio.

Market price divided by earnings per share. Low P/E (under 15 for most industries) suggests cheap. High P/E (over 25) suggests expensive. Use forward P/E for growth stocks and trailing for stable businesses.

Price to book (P/B) ratio.

Market price divided by book value per share. Below 1 means the stock trades below the value of its net assets. Graham's classic value approach focused on P/B under 1 with strong balance sheets.

Price to free cash flow (P/FCF).

Market price divided by free cash flow per share. More reliable than P/E because earnings can be manipulated through accounting choices. FCF is harder to fake.

EV/EBITDA.

Enterprise value divided by EBITDA. Adjusts for debt and cash. Used to compare companies with different capital structures.

Return on equity (ROE).

Net income divided by shareholder equity. Measures how efficiently the company generates profit from invested capital. Above 15 percent sustained is high quality.

Debt to equity ratio.

Total debt divided by shareholder equity. Lower is safer. Heavily indebted companies have less margin for business setbacks.

Dividend yield.

Annual dividend divided by price. Higher yield on otherwise quality stocks can signal value. Very high yields often signal trouble (the price has dropped, pushing yield up).

The Buffett refinement

Warren Buffett evolved Graham's classical value approach to focus more on business quality than purely on statistical cheapness.

Graham would buy any company trading well below book value. Buffett prefers great businesses at fair prices over fair businesses at great prices.

The Buffett framework adds.

Economic moat. Sustainable competitive advantage that protects long term returns. Network effects, switching costs, intangible assets, low cost production, efficient scale.

Quality of management. Honest, capable management with shareholder oriented capital allocation.

Predictability of earnings. Stable, predictable cash flows from established businesses.

Long term growth runway. Markets the business can grow into over decades.

The Buffett approach pays higher multiples for quality businesses with durable moats. The reasoning is that quality compounds over time, and the slightly higher entry price is justified by the longer holding period.

What value investing requires

Patience.

The gap between purchase price and intrinsic value may take years to close. The value investor holds through periods when the stock continues to lag while the underlying business improves.

Contrarian temperament.

Value stocks are often unloved by the market. Buying what others are selling requires the ability to act against consensus. Most retail investors cannot do this consistently.

Analytical work.

Estimating intrinsic value requires reading 10K filings, understanding the business, analyzing the competitive landscape. Hours per company.

Acceptance of underperformance periods.

Value strategies underperform growth strategies for years at a time. The 2010 to 2020 period was particularly hard for value investors. The strategy still produces long term returns but the patience required is significant.

Long holding periods.

Value investing is not trading. Holding periods are typically 3 to 10 years. The trader looking for monthly returns is in the wrong strategy.

What kills value investors

Value traps. Stocks that look cheap on metrics but have permanent business problems. The cheap stock keeps getting cheaper because the underlying business is in secular decline.

Catching falling knives. Buying during a decline without confirmation that the decline is overdone. Mean reversion only works on quality businesses with temporary problems.

Concentration risk. Believing too strongly in a single value thesis and putting too much capital into it. The diversified value portfolio outperforms the concentrated one over long periods.

Abandoning the strategy during underperformance. The value investor who switches to growth after years of value underperformance often catches the growth top and misses the value recovery.

Ignoring quality. Buying purely on statistical cheapness without considering whether the business is durable. Graham's approach worked in his era. Modern markets reward quality more.

The retail implementation

For most retail, value investing through index ETFs is the practical approach. Value factor ETFs (VTV, VLUE, IVE) provide diversified value exposure without requiring individual company analysis.

For those who want to pick individual stocks, focus on a small portfolio of high quality businesses with sustainable moats trading at reasonable valuations. 10 to 20 names. Multi year holds. Quarterly fundamental reviews.

Read the books. The Intelligent Investor, Security Analysis, The Snowball (Buffett biography), Berkshire Hathaway annual letters. The framework is more important than the specific tactics.

Where the audit fits

The audit is for active trading. Value investing is long term holding. The two strategies can coexist in a portfolio. The active trading portion produces income. The value portion produces long term compounding. The audit structures the active portion. The value portion runs separately. Five to seven pages.