A Beginner’s Guide to Value Investments
When talking about investments, it is almost impossible to find the most efficient way of making investments. While there are many strategies to making the right investments and ways of doing it, nobody has been able to get it completely right. One such way of investing is value investing. It may not be the most attractive way of making investments as it doesn’t generate huge profits in a short period of time. But ain’t the slow and steady one wins the race? Here is a beginner’s guide to value investments to get started.
What is Value Investment?
Value investment refers to the process of buying assets that have a current market value lower than their intrinsic value. There are always some instances where assets lose their value because of external factors like market volatility, geopolitical tensions, inflation rates, and so on. In such times, the value of some assets may reduce but their intrinsic value always remains the same.
So, in value investing, investors buy assets that are currently priced low because of market downturns but hold value in the long run. This is based on the principle that whenever a new thing emerges in the market, its value shoots up considerably, even though it has no real value or utility for its users. The price of such assets is bound to decrease when it settles in the market and people begin to know more about them.
On the other hand, some assets may witness periods of downfall but the fact that they have some real value and use cases for their users, makes the prices of such assets increase over time. Thus, the value investors seek such assets out and invest in them under the value investing system.
Common Terms Used in Value Investments
Value investments are a special area of investments in themselves. It consists of some special terms that you, as a beginner, may not be able to understand. So, here are some common terms that you should know about before beginning your journey to value investing.
The book value is equal to the value of total liabilities of the company subtracted from the value of total assets of the company, as given in the balance sheet of the company.
It is quantitative to predict the price of an asset while assuming that the present-day value of the asset is equal to the sum of its future dividends when discounted to its current value.
Working capital is the difference between total assets owned by the company at present and the total liabilities of the company that are existing right now. This helps in measuring the liquidity of the company in order to meet its short-term obligations.
Operating Cash Flow
Operating cash flow is the value of the cash that is generated by the core business operations executed in a company. This helps the company in finding out the contributing factors that are leading the cash flow.
Free Cash Flow
The difference between the operating cash flow and the capital expenditures of the company is known as free cash flow. This is basically a measure of the company’s real income or profits.
Margin of Safety
Margin of safety of a product is the difference between its market value and intrinsic value. A high margin of safety helps an investor to overcome market downturns.
The intrinsic value of an asset is the real value of the asset without considering any effects of external factors like brand strength, product momentum, the team, geopolitical factors that are beyond the control of the company. There are different methods to calculate the intrinsic value of an asset such as cash flow analysis, dividend discount models, and so on.
It is a method of calculating the present value of an asset. It involves discounting the future cash flows at a suitable discount rate to find out the overall appeal of the investment to the investor.
Principles of Value Investments
Here are the five most important principles of value investments that are sure to turn your investment strategy into success.
Power of Compounding
The power of compounding states that when an investor invests a given sum of money for the long term, they gain higher profits. On the other hand, the same amount of money when invested for a short period of time gives lower returns to the investors. This is why experts suggest young professionals start investing early in their life so that they can accumulate enough capital till their retirement.
Margin of Safety
Margin of safety is the difference between the market value of an asset and its intrinsic value. The rule of margin of safety states that the buyers are more likely to buy assets when their prices are low. However, doing so doesn’t guarantee the success of your investment strategy.
Safe and Steady Returns
Nobody is going to get rich overnight. Even if they do, the money may not last forever. The same theory applies to value investments. As a beginner, you may also feel tempted to invest in assets that will explode in a small amount of time. But the fact is the assets that are increasing in value very rapidly have an equal likelihood of depreciating at the same pace. Therefore, one must always look for investments that are gradually increasing over time and are safe in nature.
Diversifying your value investment portfolio is the key to ensuring returns at the end of every year. It is a very important principle of investments that investors must strictly follow to prevent their portfolios from getting hurt during rough times.
Keeping Some Idle Cash
Keeping some idle cash helps you in buying assets that may be available at highly discounted rates in volatile markets. Therefore, keeping idle cash not only helps you in buying additional assets but also helps in diversifying your portfolio and earning returns in the long run.
How to Begin Value Investments?
A guide to value investments is complete without a well-planned way to do it. So, here’s a three-step process to begin your value investing journey.
1. Prepare a List
The first step in beginning value investments is to prepare a list of assets that are available to you. This is an essential step as it allows you to choose the assets which have actual value for the investor. Here are a few things to consider while preparing this list.
- Return on Equity > 15%
- Debt to equity ratio < 1.5
- Low PEG Yield and Dividend Yield
2. Shortlist Some Options
Once you are done preparing a list of the assets that look appealing to you, narrow the bracket further by shortlisting the assets further. Here are some things that you can look for in the assets.
- Availability of market growth drivers
- Moderate capital expenditure to maintain the value
- Competitive advantage
- Hedging power
- Understandable model
3. Calculate their Intrinsic Value
Finally, calculate the intrinsic value of each asset while leaving a safety margin of around 25-35%. The safety margin helps you to cushion your portfolio against rough market conditions.
While choosing value investments, make sure to follow this guide and choose the right assets for you. Also, it is important to diversify your portfolio whenever you are making any kind of investment. One should never put all their eggs in one basket because if one goes bad, the entire basket may go bad.