Basics of Value Investing

That comparison needs a second number to compare the price against. That number is intrinsic value: your estimate of what a business is actually worth, judged from the business itself — what it earns, what it owns, what it owes, what it's likely to earn later. You arrive at it by working through the company's finances rather than by looking at its stock chart.

Once you have an estimate, the two words that follow are simple. A stock trading below your estimate is undervalued. A stock trading above it is overvalued. The bet is that the market eventually prices the company closer to what the business is worth — that undervalued stocks drift up toward your number and overvalued ones drift down toward it. You profit if the price comes to you.

That comparison needs a second number to hold the price up against. That number is intrinsic value: your estimate of what a business is actually worth, judged from the business itself — what it earns, what it owns, what it owes, what it's likely to earn later. You get to it by working through the company's finances, not by looking at its stock chart.

Once you have an estimate, the words that follow are simple. A stock trading below your estimate is undervalued. A stock trading above it is overvalued. The bet is that the market eventually prices the company closer to what the business is worth. You make money if the price comes to you — and nothing forces it to.

Say you're at a yard sale and you spot an old bike.

You look it over — the tires, the chain, the paint, how much use is left in it — and you decide in your head what a bike like that is worth. That number in your head is its intrinsic value. Nobody handed it to you. You built it out of what you saw, and somebody else looking at the same bike could land somewhere completely different.

Then you check the tag. Tag lower than the number in your head, and you think you've found a bargain — that's undervalued. Tag higher, and it's overvalued.

Value investing is that, done with companies. But here is the part that makes it harder than a bike: with a bike, you ride it home and that's the end of it. With a company, you only come out ahead if other people eventually agree with your number and start paying it.

Then comes the harder part. Even when you're right, being right takes time. The market has no schedule for agreeing with you, and it can spend years not agreeing. Your only options in that stretch are to keep holding a position that isn't working yet or to abandon it — and you cannot tell from the inside which one is correct.

So the honest description of the job is: substantial work up front, then patience with no confirmation. That's the price of admission. It's also part of why the opportunity exists at all — most people won't do it.

Then comes the harder part, and it isn't the arithmetic. Even when you're right, being right takes time. The market is on no schedule to agree with you, and it can spend years not agreeing. All you can do in that stretch is keep holding something that isn't working yet, or give up on it — and from the inside, you cannot tell which of those is the correct move.

So the honest description of the job is: a lot of work first, then patience with nobody confirming anything. That's the cost of doing this. It's also part of why the opportunity is there at all — most people won't put up with it.

Now the hardest part, and it isn't the math.

Suppose you're right. Suppose the company really is worth more than people are paying. Nobody rings a bell. Nobody comes and tells you that you were right. The price can sit exactly where it is for years while you wait for it.

And here's the thing that makes it genuinely hard: while you're waiting, being right and being wrong feel exactly the same. Both of them are just sitting there, watching nothing happen. You can't tell them apart from the inside.

So this is what you're signing up for — a pile of work first, then a long stretch with no one to confirm anything. Most people won't do that, which is part of why there's anything left to find.

Prices that have tended to move less. Volatility is how much a price swings up and down, usually measured against a benchmark — the index you compare performance to, such as the S&P 500®. Value stocks have historically shown lower volatility than growth stocks. That isn't magic; it follows from what value stocks usually are. Companies that look cheap relative to their earnings and assets tend to be established, mature businesses with a long operating record, and the market revises its opinion of those more slowly than it revises its opinion of a company whose entire case is what it might become.

Lower volatility means a smoother ride, not a safer outcome. A stock can fall a long way slowly. Read the risks below before you file "less volatile" under "less likely to lose money" — they are not the same claim.

Prices that have tended to move less. Volatility is how much a price swings up and down, usually measured against a benchmark — the index you hold performance up against, like the S&P 500®. Value stocks have historically been less volatile than growth stocks. That isn't magic. It follows from what value stocks usually are: settled, long-running businesses with a real track record. The market changes its mind about those more slowly than it changes its mind about a company whose whole case is what it might turn into someday.

Now the part to be careful with. Less volatile means a smoother ride, not a safer outcome. A stock can fall a very long way slowly. Read the risks below before you file "moves less" under "less likely to lose money" — those are two different claims.

Prices that have tended to move less. Some companies' prices leap around from one day to the next. Others move more gently. Volatility is the word for how much a price jumps around. To say whether a price has moved a lot, you have to compare it to something — usually one big list of companies that stands in for "the market." That list is called a benchmark.

Companies that look cheap next to what they earn and own are usually older, settled businesses that have been doing the same thing for a long time. People change their minds about those slowly. Compare that to a brand-new company whose entire story is what it might become someday — opinions about that can flip overnight.

Now read this next part carefully, because it's the part people get wrong. A gentler ride is not a safer one. A price can fall a very long way slowly. "Moves around less" and "less likely to lose you money" are two different claims, and the first one does not get you the second.