This sums up the difference between value and price and its importance
(Image source: http://blog.wallstreetsurvivor.com/2013/08/29/the-basics-of-value-investing/)What is value investing? It is the strategy of picking stocks which are selling below their intrinsic value. To find out more on how to find the intrinsic value of a stock, look at a blog post done on the Dividend Discount Model and Discounted Cash Flow Model. In addition to the dividend discount model and the discounted cash flow model introduced in that segment, there is also another way of valuing companies using comparables, which include P/E ratios, P/B ratio and dividend yield. This values the company based on the fundamentals of the company, be it earnings, book value, free cash flow or dividends.
Through value investing, we are able to pick stocks that we think are worth more than the price we are paying for them due to their good earnings, dividends or book value. This may sound quite intuitive actually, why would anyone pay a premium over their perceived value of a company? But it happens, especially in a bull market when everything is up and investors are in a good mood. This lack of common sense also explains why the same company can be valued very differently at different times though there may be no changes in the nature of its business or its fundamentals.
Value investing is not the same as speculating. It is about buying shares that are selling below your intrinsic value of the business with a margin of error (more covered later) and selling the shares. You have to look at the share as a small part of a business rather than just a stock ticker. Instead of relying on previous prices and current trends with regard to the price, as a value investor, you would be looking at the fundamentals of the business through its financial statements and come up with your own share price, relatively independent of the market price. Then you would compare your valuation and the actual share price to determine if it is a good buy.
This also doesn't mean that you should just buy shares and hold them for life. If the share price happens to be lifted by some external forces and has increased past what you think is a reasonable valuation of the stock, by all means sell it. Though you stand to make more if you sell later by trying to time the market (targeting peaks and rock-bottoms), this is a far more sustainable method. But when value your shares, don't forget that you may be wrong and ensure that there is a margin of error, the difference between your valuation and the price that you are paying, which can absorb the difference should you be wrong.
Some examples of value investors include Warren Buffett and Benjamin Graham, the "father" of value investing and also writer of The Intelligent Investor where he creates an apt illustration of Mr. Market. Imagine the stock market to be a person called Mr. Market and every day, he will come up with a price to either buy or sell a business. Would you be worried if one day Mr. Market gave you a very low price for your business? No, you shouldn't be, as a matter of fact, you should be buying the business from him as you think that the business is worth more than the price that he is offering it for. Then what happens when he gives a high valuation for a business that you own? You would sell it as you think he is giving a higher price than it is worth. Now, understand that shares and stock are no more than just small parts of a business that buy and sell. Wouldn't the same logic apply here as well then?
To conclude, I will leave some thinking questions here:
1. Have you ever wondered why the market can swing so much day to day?
2. How much of the news that floods the market actually detrimentally affects the companies listed?
3. Why is the market so imperfect?
I don't have the answers to these questions, but thinking about them give us a good perspective on the merits of value investing as it bypasses all of the market noise and gives good, sustainable returns
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