When investing in the stock market, it is almost obvious that your objective would be to reap returns on your investment either through dividends or capital gains. Read more on the reasons you would want to invest in the stock market here.
In this two part series we will take you through the two main strategies you can apply while investing in the stock market namely value investing or speculative investing.
Lets start with Value Investing.
Value Investing
“…Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business who’s earnings are virtually certain to be materially higher five, ten and twenty years from now.” ~ Warren Buffett.
The objective of value investing is to identify and buy stocks which are trading at a market price lower than their intrinsic value – deemed to be their “real” value. The rationale of value investing is that the stock market over reacts to company news and events thus leading to share prices that either well above or below the intrinsic value of the share which is determined by analyzing the company’s fundamentals such as its future earnings, how much debt it owes or the quality of its management.
Value investing assumes that the market value (price) of a share will eventually rise further above its intrinsic value after a period of time which can be up to several years. The value investor therefore takes advantage of the fact that some shares have a low market price relative to their intrinsic value by buying them and holding them until the stock market discovers the shares’ value and their price rises.
For example, a share could be trading at KES 40 per share at the stock market but have an intrinsic value of KES 50 based on a value investor’s calculation meaning that the share is undervalued by KES 10. This difference between the intrinsic and market value of a share is known as the margin of safety and is a measure of how “safe” the share investment is.
Having bought the share at its market price of KES 40, the value investor will reap good returns when the market finally realizes the value of the share and it begins trading at or above its intrinsic value of KES 50. More so, a value investor’s intrinsic investigation into a share could discover that it is paying out high dividends relative to its current market price thus bring high returns in this way.
How does a value investor determine the intrinsic value of a share?
The intrinsic value of a share is not an exact number and varies from one investor to another depending on how they analyze a company and its share. For example, one investor may rely more on a company’s past earnings while another may look to the current management as an important factor in putting value to a share. The common aspect of finding the intrinsic value of a share is that fundamental analysis is applied to the share and company.
Fundamental analysis involves looking deeper than just how the share has traded in the past (which is known as technical analysis) and into overall company and economic data or information that affects the share’s current and future value. It includes looking at all the vital parts of a business from a financial perspective. Aspects of fundamental analysis include but are not limited to a company’s: assets, current and future earnings, balance sheet, income statement, management, strategy, level of debt, valuation, market growth, relevant macro economic factors etc.
To assist with fundamental analysis, financial ratios such as leverage ratios – which measure a company’s method of financing or its ability to meet financial obligations – have been in common use. Depending on what a value investor deems important in determining a stock’s intrinsic value, she may look at the above or other elements of fundamental analysis in calculating the intrinsic value of a share.
One way to find out the intrinsic value of a share advocated by economists Irving Fisher and John Burr Williams more than 60 years ago is to calculate the present value of the dividends that an investor will derive from the share over a specific period in the future. This method is however subject to the uncertainty in how much dividends will be paid out by a company year-to-year.
Benefits of Value Investing
- Lower Risk – Studies have shown that investors who buy stocks based on their intrinsic value have higher chances of success in the stock market than investors who buy based on stock price growth only.
- Higher Margins – Because value investors buy in to a share while it is still highly undervalued, they reap bigger margins compared to speculative investors who buy in once the share’s price has already began to rise.
- Long Term Returns – Value investing ordinarily involves a lot of patience before an undervalued share has been recognized by a market and rises. It is therefore an ideal investment strategy for investors looking for long term returns.
Tomorrow, in part 2 of this series, we will look into the stock market strategy of speculative investing.