May 16, 2020 ▪ 5 min read Investing
Here's a few notes on value investing.
This is an important truth that is easy to forget; just because something is bought or sold at a certain price doesn't mean it's fairly valued. Warren Buffett once said: "Price is what you pay. Value is what you get." (at least according to Google!). It doesn't really matter who said it (probably Warren Buffet), but what this means is that you can pay a low price for something with a high value, but also pay too much for something with a low value.
The trick to value is this: value is determined by yourself. I might value something a lot higher than someone else, especially when it would provide me with something it wouldn't neccessary provide someone else (productivity and similar services are good examples).
In investing, it's somewhat safe to assume that most rational people want to increase their overall wealth (not always in monetary terms).
How to determine value?
The efficient-market hypothesis states that the market is always fairly valued (value is always equal to true value). Basically; you can't beat the market, and the only way to gain wealth is random movements (i.e. speculation) or cheating. This approach is convenient (for academics), but not very reasonable, and we want to be reasonable. So, value investors should ignore this and assume markets are inefficient (i.e. there exist some information asymmetries).
Assuming that the market is inefficient, then how do we determine value? This is the fundamental problem for most value investors, and it's more like a process than systematic method. It's also important to mention that most investors have their own unique approach. The basics; when buying or starting a business, the investor or founder own 100% of the shares. In this case, its value could be whatever the investor paid for the shares, or all its assets, but more realistically, it would be a combination of its assets and future earnings. It's possible to forecast earnings a few years into the future, then assume a set growth rate forever (read more about terminal value).
To determine value, we'll first need to estimate future earnings.
A simple method to estimate future earnings is to represent earnings as a function of revenue and expenses, where revenue should increase (preferably!), and expenses should decrease, i.e. margins should get better with time. In US; all public companies report revenue and expenses in their quarter and annual reports (here's a 10-Q filing for Dropbox). These filings also include assets and other relevant numbers (such as cash flow and various indicators).
It's especially important to keep an eye on a few operations fields:
From the operations fields above, we can determine various business health and sanity ratios, such as Gross Margin, Operating Margin, and Tax Rate, as well as determining year-on-year change in revenue and expenses (ratios shouldn't be unrealistic and not fluctate much).
In the filings, investors can also find a few important balance sheet fields:
From the balance sheet fields above, we can determine some additional ratios; "Tangible Working Capital" (what the company need to keep the business running), Return on Equity, Return on Tangible Equity, and "Return on Tangible Working Capital" (what investors get from capital needed to run the business). Investors can also go one step further; goodwill as a percentage of share price (basically intangibles per share, too much and you don't actually own anything tangible), Return on Research Capital (especially important for research-heavy companies), Price to Research and Development (to compare between business investments in research and development).
How to build a financial model?
Based on the fields and ratios mentioned above, investors can build a model to forecast earnings based on estimated future revenue and operating expenses (keeping margins and sanity ratios in line with historical values or within industry specific ranges is usually a good idea). This process becomes easier with specific knowledge in whatever industry the business is operating in, investors need to be able to estimate likelihood of various events, sales targets, new product impact, and so on. A good model should estimate revenue and expenses for at least a couple of years into the future, then assume none or negative growth until earnings are close to zero (this could be many years into the future).
How to determine net present value?
To determine what an investor should pay today, we first need to obtain the net present value. This is basically the sum of the discounted cash flow (or future earnings) and current net cash. When discounting cash flows, a good discount rate would be the risk-free rate plus a market risk premium, e.g. likelihood that estimated future earnings does not happen, minimum expected return, or relative risk compared with peers (again, this is probably different for each investor). This would give a good estimate of value, and hopefully not too different from current market value.
A good discount rate should also take into account specific knowledge in the industry, something the investor know less about would naturally result in a higher discount rate, i.e. higher risk.
A common and potentially harmful approach is to "buy low and sell high", often based on market movements and nothing else. This is called market timing, which is similar to market speculation, and not recommended by anyone respectable (AFAIK).
A similar but better approach is to buy when price is lower than net present value (including some margin of safety), this basically means to buy and hold until price on market is higher than your estimated net present value per share (or until relative return is approaching some predefined upper limit, or accepted yield). This also means short selling when price is higher than net present value.
Is leverage, or buying on margin a good idea?
Leverage (or buying with other people's money) is a very powerful tool in investing. There's nothing fundamentally wrong about buying with leverage, assuming solid financial model and a good margin of safety (so even when model is not completely correct, the investor might get positive returns). However, it's worth to note that using leverage can result in more debt than value.
This is not investment advice. I am not suggesting that anyone should do anything mentioned in this post (nor invest in any stock or other financial instrument). Do your own research, and don't risk what you can't afford to lose.
EDIT (November 04, 2020): Cleaned up to better fit updated website format.