Value Investing 101 (how to value a company)

This post isn't for most readers, drop back in a day or two, there will be an interesting bank profiled.  I have had a number of emails recently from readers asking some basic value investing questions, and I thought I might put a simple resource out there for beginning investors to refer to.

What is value investing

Value investing is the concept of purchasing companies for less than their worth.  It's almost strange that this idea has its own title, because this is what all investors are endeavoring to do, whether it's titled value investing or not.

An investor needs to look at a stock as a piece of a real company.  A share of stock represents an ownership interest in a company that has real locations somewhere.  At their offices there are real people who go to work each day and work their hardest for you (the owner).  These people probably aren't thinking about the stock, they're thinking about the product, their upcoming vacation to Disney, and the day to day challenges they're facing.  The benefit they reap is a salary, what you reap as the owner is whatever value they generate that accrues to your ownership interest.

The idea of a value investment is to envision this real company and evaluate what it might be worth.  A great starting point is the company's balance sheet.  Their office, factories, desks, laptops, intellectual property all have some value.  Maybe the value is very small, or maybe it's significant, either way look at what the company owns.  Then look at what they owe, maybe they've mortgaged their entire future and what they own is actually owned by the bank, examining the asset and liability structure is important, after all, this is what you're purchasing a piece of.

You want to purchase this company for less than what you think they're worth.  If the company is worth $10m, then maybe a purchase a $6m is appropriate.  The key is to be a disciplined buyer.  If you decide something is worth $10m and you won't buy at more than 2/3 of their value don't cheat yourself and buy at 72%, unless you have a very good reason to violate your rule.  As a value investor you make money when you purchase a stock, you aren't hoping for the market multiple to expand, or for the company to grow into their valuation.  You are buying something worth a fixed value for less than that value.  Being sloppy on purchasing is one way to dilute your returns.

The question always comes up, what do you do when the stock price starts to fall?  The first thing to do is examine the reasons for the fall.  Maybe there are no reasons, maybe it's just moving with the market.   Think back to the actual business, think about the factories, the workers, the output; has something changed in their workday that makes them worth 2% less, or 4% less?  Most likely not, if the price continues to fall, and the actual value is unchanged consider purchasing more of the company.

How to value a company

I think people get hung up on valuation because it appears to be a financial dark science.  I have seen write-ups with complicated math and enormous tables that try to predict the future.  I'm not sure how well that stuff works, but I'd advise starting simple.  Often you never need to move beyond simple; simple valuation methods leave less room for error.

The best way to start is to screen for companies that are trading for less than book value, or for less than than a conservative earnings multiple (P/E 10, or EV/EBIT 7).  Work backwards, take a company you find in the list for less than book value and examine their book value.  Is this company's book value as strong as it looks initially?  Maybe they have a lot of goodwill, or are laden with expensive debt, discount those items.  Maybe their assets aren't as valuable as the company would like them to be, discount that as well.  Look at the adjusted book value compared to the market price, is the company still selling with a low valuation?  If so then consider buying it, when the company's value approaches your adjusted book valuation consider selling.

A similar method can be applied to earnings as well.  If the market is valuing all rubber hose manufacturers at 10x earnings and you find one selling at 6x earnings it's time to investigate.  Why is the company selling cheap, are their earnings depressed, or is there a reason they're discounted?  Determine what the reason for the discount might be, if it's a valid reason move on, if it's not a valid reason then maybe consider purchasing.

Summary

I believe the items in this post are great building blocks that any starting investor can begin to use now, and as they learn expand into more complicated item.  Don't become overwhelmed, focus on what's important, which is buying companies at a discount, and being disciplined in your process.  There is no need to jump from elementary investing to advanced investing.  A lot of the learning process happens over time with experience.  Investing takes patience and perseverance, you can't learn everything on day one!  My final piece of advice, if a company appears too hard to evaluate, move on, there are 60,000 traded companies world wide, there is no shortage of simple companies, start with those.