Learn Investment

The What and Why of Value Investing and Security Analysis

Wow! I realize that it’s been a while since I’ve posted on this here blog, but to anyone who still follows me fear not I am still alive and writing. As student having recently graduated high school and being busy with all of the things that come with that I’ve been busy. I am free however now and will continue to post on here weekly when possible.

Alright, in this post we’ll be shifting gears a little bit and talking about how what our goals are with investing and how we are going to go about attempting to achieve them. As I’ve noted in previous posts, the primary reason to engage in any kind of investment is to assure that the investor’s wealth is growing faster than inflation, that is a rise in the overall price level, corrodes that wealth’s buying power. This is also the bare minimum an investor must accomplish in order to make any kind of investing activity worthwhile. However if keeping up with inflation is all we wanted to do then we could just buy bonds or index funds that accomplish just that goal. What most investors would prefer, in my humble opinion, is to grow their wealth as much as possible while still conserving the principal amount of their investment. So with this new goal in mind one might ask why just bonds, or investment company instruments like mutual funds, ETFs, or UITs would not suffice. I am not going to lie; instead I’ll say those securities could very well fit the needs of an individual investor and even those of some institutions but for those who are interested in earning greater returns than those of the indexes and far greater returns than any bond could actually deliver, value investing is that way to go.

If you’ve never heard of value investing(which is actually quite popular in the investing community) then you may be wondering what it is or what makes me speak so highly of it. If you’re already into it then just hang on for a bit as I explain it. Value investing is not a magic formula that is going to magically make you rich, it’s not a trading or signal system, and most importantly it is not a scam. In short Value investing works by purchasing a stock that an investor is reasonably certain is selling below the true value of the fraction of ownership in a business that the stock represents and then waiting for the stock price to reach what the investor believes to be the intrinsic value of the stock and then selling it. As you might have inferred the greater the discount at which a stock is selling from its intrinsic value the greater the profit per share the investor make upon selling it at that fair price. This begs the question, how do we ascertain the intrinsic value of a stock or any other investment security? Well in order to that we have to engage in security analysis of multiple types, but they all boil down too what I explained in my last post: time value of money as well as a little bit of accounting. What value investing and security analysis do not entail is any kind of technical analysis or using past prices or price changes to predict future ones. Benjamin Graham, the father of value investing, and Warren Buffett’s graduate professor and former employer, once wrote in his famous book The Intelligent Investor “Investing is most intelligent when it is most businesslike.” By using analyzing the business behind a stock and it’s true value, we are treating our investment, even at the individual level as a business undertaking and thus are being more prudent about it.

In any case, one thing should be noted if your skill in value investing does not earn you greater returns than those of the major stock market indices it may be best to stick to using index funds until you get the hang of it or until such a time as the market presents you with a larger amount of or more deeply undervalued stocks. This is not to draw you away from value investing but to have you understand that this strategy is a long term strategy, a waiting game if you will. Waiting until your undervalued holding finally reach their true value or to liquidate yielding more than you paid for the stock, or waiting until you find an deeply undervalued stock as you search through the thousands of publicly traded equities in the world. This waiting could take weeks, months, or even years but the people with the patience and the discipline not to sell an undervalued stock are the ones who earn the greatest returns.

In my next post I seek to get in to the practical aspects of security analysis and how to get started with analyzing and valuing a business. In the mean time I recommend reading this website, which does a MUCH better job of explaining basic accounting than I ever could. While it may be possible to understand my next few posts without reading up on accounting I would highly recommend it, and I think accounting is actually more interesting than the media may lead you believe.

Disclosure: The author is not an attorney at law or a finance professional. He did not own any securities at the of this post’s writing and is not receiving any compensation for this post.

If anyone has any questions just post them in the comments section below.

-Mohit D. Patel

Author, The Not So Intelligent Investor

It’s About Time (Value of Money)!

Since in my last post I discussed inflation and why people invest in the stock market, I decided that a natural next concept to introduce would be something called time value of money or TVM for short. This concept is the basis for most everything in finance. Stock investing, private equity, venture capital, bond investing, savings and loans, capital budgeting and much more hinge on the concept of TVM so I’ll try to explain it as clearly as possible.

At the base of it, time value of money means that 1 dollar today is worth more than 1 dollar in the future, and conversely 1 dollar today is worth less than 1 dollar one year ago. It may be tempting to attribute this to inflation but that is not the reason that this is true. The reason that a dollar today is worth more than the same amount in the future is because a dollar today can be invested until next year at which point it that dollar plus the return from investing would be more than just the one dollar being given to you one year from now. If this does not make sense to you, that’s okay, the followinf example will help clarify.

You have two people James and Sally. I tell them each that I’ll give them $100, they can receive it now(March 29, 2014) or they can receive it exactly one year from now (March 29, 2015). Naturally Sally takes her $100 now, James decides that he would rather receive his $100 exactly one year from now. Sally goes home and puts her money in her bank account which we’ll say pays 5% interest compounded annually. On March 29 2015, one year from the starting point, I give James his $ 100 dollars and he puts it in his bank account. At this point Sally has $105 in her account while James has only $100. Time value of money is true because any money that a person receives today can be invested and earn returns.

In the case of James and Sally, we would say that the presesnt value of both James and Sally’s money was $100. We would also say that the Future Value of James’s money was $100, while the Future value of Sally’s money was $105 because she earned interest on her money.

In order to further understand this concept we must consider the TVM formulas. OH NO MATH!!!!! Relax, there is no reason to panic when it comes to this math, it’s really easy to understand and it applies the same way across all areas of finance.

The future value formula is as follows.

The Future Value of Money Formula

The Future Value of Money Formula

FV is your future value and in the case of this formula, the number that we are trying to find. PV is the present value of money, as I said before this is the amount of money that you have right now, or in other words the amount of money is being invested. The variable is your interest rate if you are lending money or your rate of return if the money is invested in stocks. The variable is the number of compounding periods per year, which means the amount of times you take the returns you’ve made and reinvest them. Finally, the variable  is the number of years that you are keeping your money invested.

In the case of Sally if we substitute in the appropriate numbers into the formula we get the result shown below.

FV sally

And of course when we work this out we do get $105.

The other formula used in TVM is when we are told what our future value will be and we have to figure out what that would be worth toady. For that we would use something called the present value formula which is shown below.

 

As you can see all I did was use algebra to isolate the PV variable from the previous formula. Suppose we knew that Sally had $105 in 2015 and that her bank paid 5% interest compounded annually and we wanted to find out how much she started with. All we’d have to do is fill out the formula.

PV sally

The Present Value of Money Formula

And when this is simplified we do get our $100 starting amount.

I understand that all of the math in this might come off as boring now, but it is a necessary evil and it will come in use when I discuss things like dividend discount and discounted cash flow valuation techniques for stock valuation. It will also come in use when learning what it means to beat the market or to beat a benchmark.

If you have any questions please post them in the comments below and I will attempt to get back to you.

As always, thanks for reading!,

Mohit D. Patel, Author

 

Disclaimer:

The author is a student, not an attorney at law or finance professional. As such, this article is not intended to constitute legal or finance advice and is offered as is for purely educational purposes. The author is not liable for any decisions a reader makes based on the content this article.

If you have any questions please post them in the comments below and I will attempt to get back to you!