Guide to Value Investing
By J. Royden Ward, Analyst and Editor, Cabot Benjamin Graham Value Letter
Value
investing is about finding stocks that the market has not correctly
priced...in other words, a stock that is worth more than is reflected
in the current price. Many people have made fortunes using a
value-based approach to investing. Value investing has been proven to
work well over time if you buy carefully and hold for the long term.
Value Investing
Value investing, perhaps more than any
other type of investing, is more concerned with the business and its
fundamentals than market factors or a stock’s price. Fundamentals
include earnings growth, dividends, cash flow and book value.
If
the fundamentals are sound, but the stock’s price is below its
intrinsic value, the value investor knows that the market has
incorrectly valued the stock and it is a likely investment candidate.
When the market corrects that mistake, the stock should experience an
increase in price.
Intrinsic Value
Current accounting standards are adequate
for measuring buildings and equipment (book value), but as our economy
has moved to a more technology/knowledge-base, many of these
intellectual assets never show up on financial statements.
Value
investors acknowledge that their target investment company is much more
valuable as an ongoing business (expected cash flows, etc.) than its
assets (market value). In many cases, it is the intangibles—patents,
trademarks, research and development, brand, and so on—that drives the
expectations of future growth, not hard assets.
Coming up with the intrinsic value of a stock is a complicated process and there are a number of ways to get to the number.
To
determine a company’s intrinsic value, the Benjamin Graham Value Letter
calculates discounted earnings per share. This is calculated by
projecting current earnings forward 10 years and discounting the
forward earnings back to the present using the current 10-year Treasury
Note rate of interest adjusted by the quality of the company.
In
addition to a company’s intrinsic value, the Benjamin Graham Value
Letter also considers a company’s historic value to determine its
value. A company’s historic value is calculated from the 10-year
history of prices relative to revenues, cash flow, earnings, dividends,
and book value.
Margin of Safety
One
of Benjamin Graham’s best-known factors in purchasing a stock was the
Margin of Safety. This method of stock selection continues to be used
by Warren Buffet and others.
Graham’s Margin of Safety simply
means buying companies that are cheap relative to their intrinsic
value. If a company can be bought at a significant discount to its
intrinsic value, it is a good value. For example, if we believe the
intrinsic value of a company is $40 per share, we apply a margin of
safety and lower the target buy price to $36 per share.
Using
Graham’s criteria, the Cabot Benjamin Graham Value Letter determines
optimum Maximum Buy Prices and Minimum Sell Prices for stocks in order
to achieve results similar to Benjamin Graham. These targets are listed
in each issue of the Benjamin Graham Value Letter for every recommended
stock.
Our target price is based on a combination of estimates
derived from intrinsic value (discounted earnings per share) and
historic value (derived from historic results of the company). The
ratios are projected forward to derive an estimate for a current
estimated Maximum Buy Price.
The Minimum Sell Price is based on
a combination of estimates derived from discounted earnings per share
and the 10-year history of prices relative to revenues, cash flow,
earnings, dividends, and book value. Each stock is expected to reach
its Minimum Sell Price within one to three years.
Conclusion
The main goal of the Cabot Benjamin Graham
Value Letter is to provide you with exceptional stock recommendations
using the techniques pioneered by Benjamin Graham. Our second goal, no
less important, is to give you the confidence to buy those stocks and the patience to
hold them to fruition. If we can achieve those goals, we’re confident
you’ll achieve yours, and together we’ll have a long and prosperous
relationship.
About Benjamin Graham, the Father of Value Investing
How Cabot Applies the Benjamin Graham Value Strategy
Step-by-Step Guide to Investing with the Cabot Benjamin Graham Value Letter
Success Stories from the Cabot Benjamin Graham Value Letter