Lesson 1 of 7
What value investing is
The cheapest part of a market holds two businesses that look identical from outside, and only one is priced below its value.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
Who writes thisEditorial processLinkedIn (opens in a new tab)X (opens in a new tab)
In one minute
- Value investing means paying less than the cash a business will produce for its owners is worth.
- The cheapest part of any market holds two businesses that look alike from outside: one is priced below its value, and one is priced correctly because its earnings are about to fall.
- No ratio separates the two on its own.
Value investing is buying a share for less than the business behind it is worth, based on the cash it will hand its owners over time rather than on where its price has been. Graham's test in chapter 1 of The Intelligent Investor asks how the purchase was made, not what was purchased: analysis that shows safety of principal and an adequate return makes it an investment, and anything short of that is speculation.
Price against the business behind it
RowsBusinessColumnsPrice
Strong, Cheap
Strong and cheap
Strong, Expensive
Strong and expensive
Weak, Cheap
Weak and cheap
Weak, Expensive
Weak and expensive
Two businesses, one ratio
The two cells on the left of the grid share a price. One is cheap because it is out of fashion. The other is priced correctly, because the market already expects its earnings to fall and is right to expect it. A price to earnings ratio, a price to book ratio, any single number built from the price, describes both cells identically. That is not a flaw in the ratio. It is a description of what a ratio can tell you and what it cannot.
It can look wrong for years
A discipline that buys only at a wide discount holds cash or unfashionable shares while other prices rise. Nothing in the arithmetic says how long that lasts, because a discount contains no date.
What tells the two cells apart
Separating a business priced below its value from one correctly priced to fall takes more than the ratio that put them in the same cell to begin with. It takes the accounts the business files, what it owes and to whom, what it earns on the capital already invested in it, and how easily a competitor could take that away.
Check yourself
Two companies trade at the same low P/E. What does the ratio alone tell you about which one is priced below its value?
- The one with the lower revenue growth is
- Nothing. Both look identical from the ratio alone
- Whichever share has fallen furthest is
Show the answer
Answer: B.
A ratio built from price cannot distinguish a business the market has overlooked from one correctly priced for falling earnings. Both can print the same number.Company B trades at 8 times earnings because the market expects its earnings to fall, and the market is right. Where does it sit in the grid?
- Strong and cheap
- Weak and cheap
- Weak and expensive
Show the answer
Answer: B.
It is cheap for a reason the price already reflects. From the ratio alone it looks like the cell above it.What should you expect from a method that only buys when a wide discount exists?
- A return that beats the market every calendar year
- Long stretches of holding cash or unfashionable shares while other prices rise
- A shorter holding period than the market average
Show the answer
Answer: B.
A discipline that waits for a wide discount sits out the stretches where prices rise without one appearing, and nothing in the method says how long such a stretch runs.Sources
- Graham, The Intelligent Investor, revised edition 1973, chapter 1, on the line between an investment operation and a speculation.
What this leaves out
- The two-company example is invented and illustrative. It names no real business.
- This lesson reports what the method claims for itself, not evidence that it beats the market over any period.
- Nothing here is advice about any security.