Value Investing by Research Wings

Question : What is Value Investing?
Answer from Wikipedia: Value investing is an investment paradigm that derives from the ideas on investment that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis. Although value investing has taken many forms since its inception, it generally involves buying securities that appear underpriced by some form of fundamental analysis. As examples, such securities may be stock in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-to-earning multiples or have low price-to-book ratios.

Question : Why Value Investing?
Answer by Warren Buffet : “Long ago, Ben Graham taught me that 'Price is what you pay; value is what you get.'”
Warren Buffett, Berkshire Hathaway, 2008 Letter to Shareholders

Question : How Value Investing?
Answer from Investopedia:

5 Must-Have Metrics For Value Investors

1. Price-to-Earnings Ratio
While the price-to-earnings ratio (also known as the P/E ratio or earnings multiple) is likely one of the best-known fundamental ratios, it's also one of the most valuable. The P/E ratio divides a stock's share price by its earnings per share to come up with a value that represents how much investors are willing to shell out for each dollar of a company's earnings.

The P/E ratio is important because it provides a measuring stick to compare valuations across companies. A stock with a lower P/E ratio costs less per share for the same level of financial performance than one with a higher P/E. What that essentially means is that low P/E is the way to go.

But one place where the P/E ratio isn't as valuable is when you're comparing companies across different industries. While it's completely reasonable to see a telecom stock with a P/E in the low teens, a P/E closer to 40 isn't out of the line for a high-tech stock. As long as you're comparing apples to apples, though, the P/E ratio can give you an excellent glimpse at a stock's valuation. (Learn more about the P/E ratio in our Investment Valuation Ratios Tutorial.)

2. Price-to-Book Ratio
If the P/E ratio is a good indicator of what investors are paying for each dollar of a company's earnings, the price-to-book ratio (or P/B ratio) is an equally good indication of what investors are willing to shell out for each dollar of a company's assets. The P/B ratio divides a stock's share price by its net assets, less any intangibles such as goodwill.

Taking out intangibles is an important element of the price-to-book ratio. It means that the P/B ratio indicates what investors are paying for real-world tangible assets, not the harder-to-value intangibles. As such, the P/B is a relatively conservative metric.

That's not to say that the P/B ratio isn't without its limitations; for companies that have significant intangibles, the price-to-book ratio can be misleadingly high. For most stocks, however, shooting for a P/B of 1.5 or less is a good path to solid value. (See Digging Into Book Value to learn how book value per share is normally calculated.)

3. Debt-Equity
Knowing how a company finances its assets is essential for any investor – especially if you're on the prowl for the next big value stock. That's where the debt/equity ratio comes in. As with the P/E ratio, this ratio, which indicates what proportion of financing a company has received from debt (like loans or bonds) and equity (like the issuance of shares of stock), can vary from industry to industry.

Beware of above-industry debt/equity numbers, especially when an industry is facing tough times – it could be one of your first signs that a company is getting over its head in debt.

4. Free Cash Flow
While many investors don't actually know it, a company's earnings almost never equal the amount of cash it brings in. That's because companies report their financials using GAAP or IFRS accounting principles, not the balance of the corporate checking account. So while a company could be reporting a huge profit for its latest quarter, the corporate coffers could be bare.

Free cash flow solves this problem. It tells an investor how much actual cash a company is left with after any capital investments. Generally speaking, it's a good idea to shoot for positive free cash flow. As with the debt-equity ratio, this metric is all the more significant when times are tough. (Watch out for accounting trickery when looking at free cash flow, see Free Cash Flow: Free, But Not Always Easy to learn more)

5. PEG Ratio
The price/earnings to growth ratio (or PEG Ratio), is a modified version of the P/E ratio that also takes earnings growth into account. Looking for stocks based on their PEG ratios can be a good way to find companies that are undervalued but growing, and could gain attention in upcoming quarters. Like the P/E ratio, this metric varies from industry to industry. (For further reading, check out Move Over P/E, Make Way For The PEG.)

Going Beyond the Numbers
When it comes to investing, the numbers aren't everything. There are times when low valuations are justified, and there are qualitative metrics – like management quality – that also factor into a company's valuation. Just because a stock seems cheap doesn't mean that it deserves to increase in value.

Ultimately, the only way to improve your fundamental analysis skills is to put them into practice. With these five must-have fundamentals under your belt, you're well on your way to finding the most undervalued stocks on the market.

Read more: 5 Must-Have Metrics For Value Investors | Investopedia 
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Question : Are the above question completes Value Investing?
Answer: Looking for the value of the investments is a bigger preposition. To know what it worth you must know what it is. Unless you understand what it is, it will always be tough to say what it is worth/value it has. Value Investing is a preposition where you tend to learn more and more about the stocks you are willing to evaluate. Here curiosity factor plays a vital role for evaluations.

We can also evaluate the company's position with respect to the Porter’s Five Forces metrics. This metrics has following parameters to evaluate the targets' position in the competition. From we can know about it and it reads as "Five Forces Analysis assumes that there are five important forces that determine competitive power in a business situation. These are:

1. Supplier Power: 
Here you assess how easy it is for suppliers to drive up prices. This is driven by the number of suppliers of each key input, the uniqueness of their product or service, their strength and control over you, the cost of switching from one to another, and so on. The fewer the supplier choices you have, and the more you need suppliers' help, the more powerful your suppliers are.

2. Buyer Power: 
Here you ask yourself how easy it is for buyers to drive prices down. Again, this is driven by the number of buyers, the importance of each individual buyer to your business, the cost to them of switching from your products and services to those of someone else, and so on. If you deal with few, powerful buyers, then they are often able to dictate terms to you.

3. Competitive Rivalry: 
What is important here is the number and capability of your competitors. If you have many competitors, and they offer equally attractive products and services, then you'll most likely have little power in the situation, because suppliers and buyers will go elsewhere if they don't get a good deal from you. On the other hand, if no-one else can do what you do, then you can often have tremendous strength.

4. Threat of Substitution: 
This is affected by the ability of your customers to find a different way of doing what you do – for example, if you supply a unique software product that automates an important process, people may substitute by doing the process manually or by outsourcing it. If substitution is easy and substitution is viable, then this weakens your power.

5. Threat of New Entry: 
Power is also affected by the ability of people to enter your market. If it costs little in time or money to enter your market and compete effectively, if there are few economies of scale in place, or if you have little protection for your key technologies, then new competitors can quickly enter your market and weaken your position. If you have strong and durable barriers to entry, then you can preserve a favorable position and take fair advantage of it.

Reprinted by permission of Harvard Business Review. From "How Competitive Forces Shape Strategy" by Michael E. Porter, March 1979. Copyright © 1979 by the Harvard Business School Publishing Corporation; all rights reserved."

Question : Do we need to see anything in addition to above for Value Investing?
Answer : Yes, after so many years of this discoveries financial market has evolved and we have not situations were there is negative interest rate in many countries. This all was not there when this tool were discovered. Further it will be wiser to know that the coming years debt is also significant part of financing activities in most of the companies.

Here I want to add that the companies should now be evaluated at enterprise as whole. By saying enterprise/firm level evaluation, I tend to include the debt/loan/structured finance to be taken as part of the analysis. 

To evaluate enterprises a term "enterprise value" is used.

Question : What is enterprise value?
Answer from Wikipedia:
Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors (secured and unsecured) and shareholders (preferred and common). Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, and risk analysis. 

Enterprise value =
common equity at market value (this line item is also known as "market cap")
+ debt at market value (here debt refers to interest-bearing liabilities, both long-term and short-term)
+ minority interest at market value, if any
+ preferred equity at market value
+ unfunded pension liabilities and other debt-deemed provisions
– value of associate companies
– cash and cash equivalents.

Question : How to use enterprise value?
Answer: Upon knowing that it was important to evaluate the enterprise value, to use this value as part of Financial and Fundamentals of the company for evaluation.

Some of the ratios like EV/EBITDA, EV/EBIT, EV/Sales, EV/FCFF, etc are used.

Enterprise Multiple from
An enterprise multiple is a ratio used to determine the value of a company. The enterprise multiple looks at a firm as a potential acquirer would, taking into account the company's debt, which other multiples like the price-to-earnings (P/E) ratio do not include. The multiple, also known as the EBITDA multiple, is calculated as:

Also known as the EBITDA Multiple.

EBITDA is Earnings Before Interest, Tax, Depreciation and Amortization.

EBIT is Earnings Before Interest and Tax

FCFF is Free Cash Flow to Firm(Enterprise)

Calculating FCFF

The calculation for FCFF can take many forms, and it's important to understand each version. The most common equation is shown as:

FCFF = net income + non-cash charges + interest x (1 - tax rate) - long-term investments - investments in working capital

Other equations include:
FCFF = Cash Flow from Operations + Interest Expense x ( 1 - Tax Rate ) - Capex or
FCFF = earnings before interest and taxes x (1 - tax rate) + depreciation - long-term investments - investments in working capital or
FCFF = earnings before interest, tax, depreciation and amortization x (1 - tax rate) + depreciation x tax rate - long-term investments - investments in working capital

Read more: Free Cash Flow For The Firm (FCFF) Definition | Investopedia 
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Question : Do you have any other thing in mind to add to all above learning?
Answer : Yes, as you can notice that there are so many multiple to evaluate the target. I was religiously using this all multiples for evaluating the valuation of the company based on current competitive position of the target.

Recently, something came to my thought and being a student of thought, I religiously prepared a new ratio which reads Enterprise Value to Total Income to Firm Margin.

Now I break the parts of the ratio and what it tends to say

Enterprise Value - Value of the whole business including the debt part with non productive assets reduced giving better value of the target

Total Income - Total Income is very important for the business as without it no question of business shall be existing.

Firm Margin - Taking companies margin to firm into the formula allows the business competitiveness in monetary terms.

Now when I combine all of them into one ratio allows me to evaluate Enterprise to have more value for same sales with higher margins. Margins shows that the company commands premium in business and hence in valuation also.

Question : How to calculate Enterprise Value to Sales to Firm Margin?
Answer : 

Enterprise Value is Market Capitalisation Add: Debt Less: Non Current Investments

Firm Profits is Net Profit Add: Interest Less : Tax Savings on Interest Less : Other Income

Total Income is Sales Add: Other Income

Firm Margin is Firm Profits divided by Total Income

Enterprise Value to Total Income is Enterprise Value divided by Total Income (below 2 is better)

Enterprise Value to Total Income to Firm Margin is Enterprise Value to Total Income divided by Firm Margin (below 15 is investments friendly)


  1. Thanks for the insightful article on value investing.

    Enterprise value concept is difficult to grasp. The market cap is the subjective and perceptive value. This is dynamic in nature. What benefits does it bring to utilise the EV to arrive at firm's valuation ?

    1. In present scenario, when the interest rates are low than it is wise to have higher debt when you have stable business with return on capital employed more than cost of debt which will enhance the return on equity. So when a organisation use debt to generate higher cash flow for equity, it becomes wiser to look at enterprise multiple which will incorporate the usage of debt.

    2. As per Graham/Buffet, they have preference for the businesses which provide superior returns without the need for additional capital. If a business requires additional capital to generate more profit, it has become linear.

      My point was, do I need to take into account the market cap. Can I not use with the capital employed metrics (traditional) ? By taking into market cap, what additional benefits do I receive.

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