What Is Value Investing?

Often seen as the opposite of growth investing, value investing seeks to maximize returns by finding stocks that are undervalued by the market. According to this strategy, investors assess a stock's intrinsic value, often through a valuation method like discounted cash flow analysis, and compare that value with the stock price. If there is a significant margin of safety between the value and the price, meaning the intrinsic value is greater than the market value by a pre-determined amount, the value investor will buy the stock.

In this comprehensive guide to value investing, we will first discuss key concepts in value investing, value-investing strategies, and what separates it from other schools of investing; then we'll review the history of value investing with a focus on the fathers of value investing -- Benjamin Graham and Warren Buffett -- we will look at some appealing undervalued stocks today, and examine whether or not value investing is right for you.

All about value investing

What distinguishes value investing from other popular strategies is that value investors believe stocks have an inherent or intrinsic value -- a concrete number they can derive through techniques like discounted cash flow analysis. While growth investors may be more concerned about the story behind the stock or its optionality, meaning the possibility of a future that many can't yet see (for example, Amazon with its cloud computing division Amazon Web services), value investors focus on the numbers, seeking stocks they believe the market is undervaluing. If the intrinsic value is greater than the market value, they would consider buying it.

Value investors are often guided by a margin of safety that, if applied correctly, should help ensure their investments result in positive returns. For example, if an investor wants a 20% margin of safety, they would buy a stock with an intrinsic value of $100 a share, but a price of $80 per share or less. When the stock rose to $100 per share, they would likely sell it.

Value-investing strategies

The most popular value-investing technique is the discounted cash flow analysis in which investors seek to determine a company's financial future, and then discount the future cash flows based on a chosen discount rate, determined by the weighted average cost of capital (WACC) or the weighted average between the cost of equity and cost of debt. There are similar versions of this analysis that attempts to derive an intrinsic value from other cash flow, such as the dividend discount model, which focuses on dividend payouts rather than free cash flow. Such methods try to find the net present value of a stock, or what the company is worth when all future cash flows are discounted at a chosen rate.

There are other techniques for finding undervalued stocks as well, such as the asset play. In this example, investors seek out companies that have valuable assets such as land or intellectual property that aren't properly reflected on its balance sheet or in its market price. Often, market conditions change in a way that makes assets such as patents considerably more valuable than they were previously. For instance, due to its intellectual property, Marvel's market value grew by more than 20 times from the early 2000s to 2009, when Disney bought it out for $4 billion. With the growing popularity of movies based on comic-book characters such as Spider-Man, Marvel appeared to be sitting on a trove of valuable assets, which was confirmed when Disney eventually bought the comic-book powerhouse.

A brief history of value investing

More than anyone else, Benjamin Graham is considered to be the father of value investing. Graham was a professor of finance at Columbia Business School and authored "The Intelligent Investor" in 1947. Graham believed it was difficult for the average investor to beat the market, so he invented the concept of intrinsic value, though he never fully defined it and admitted that the value was ultimately determined by the investor's judgment.

After investors had been burned by the market crash in the Great Depression, when the Dow lost an unbelievable 89% over a three-year span, Graham developed a value-investing philosophy centering on the belief that large, profitable companies trading at low prices made the best investments. The professor also believed that investors should pay attention to the price-to-book ratio, focusing on stocks with a clear tangible value on their balance sheets and avoiding stocks with a price-to-book ratio of more than 1.33. In other words, he believed that a stock's price should reflect its book value or the value of its assets minus liabilities, and thought that the market price should be no more than a third (1.33) above the book value.

Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) Founder and CEO Warren Buffett and one-time student of Benjamin Graham would inherit the value-investing mantle from Graham. Buffett's folksy charm and homespun aphorisms like, "Be greedy when others are fearful, and fearful when others are greedy," and, "It is much better to buy a wonderful company at a fair price than a fair company at a wonderful price," made him a favorite among individual investors.

Like Graham, Buffett looked for undervalued stocks in companies that have steady cash flows driven by straightforward models. Historically, he has favored consumer staples companies like Coca-Cola and insurance and banking companies like Wells Fargo, and he also hunts for value stocks in sectors like healthcare, industrials, and energy.

He favors stocks with "economic moats," or a set of sustainable competitive advantages such as a brand name, network effects, or switching costs. Coca-Cola, for instance, has such a well-known brand that if the average customers wanted a soda, they would likely choose Coke over a brand they've never heard of.

Buffett has been a big advocate for value investing and his record may be the best argument for the strategy as Berkshire Hathaway has generated average annual returns of better than 20% for more than 50 years, making Buffett one of the richest people in the world -- and making early Berkshire investors millionaires.

Buffett himself complained in his most recent shareholder letter that companies are overvalued, making it difficult to make smart acquisitions. As one of the world's most respected investors, Buffett's annual shareholder letter is closely followed, and the Oracle of Omaha lends thoughts like the above about the broader market and investor behavior.

Other famous value investors include Peter Lynch, who encouraged investors to use their own insights in businesses they could observe, such as a popular restaurant chain that consistently has long lines and focused on the PEG ratio, which is like the PE ratio but factors in growth. It divides the PE ratio by the earnings growth rate so the lower the PEG ratio the better. Another well-known value investors, Seth Klarman, believes investors should ignore the macro noise and focus on risk before worrying about the return.

Limitations with value investing

While these value-investing strategies have clearly been successful for Buffett, Graham, and Lynch, there are drawbacks to value investing. Probably the biggest one is that it creates a blind spot for fast-growing start-ups that may not yet be profitable but sometimes turn into blockbuster investments. For instance, the stocks driving the market rally since the financial crisis have largely been growth stocks like the "FANG" group of stocks, not value stocks, and a smart investment in a stock like Amazon or Netflix that have jumped by thousands of percent can make up for dozens of losers, and single-handedly create wealth.

Notably, Warren Buffett admitted that one of his biggest mistakes in recent years was not investing in Amazon or Alphabet when they were smaller companies. He even acknowledged that he saw Alphabet's advertising dominance early on, but didn't buy the stock because of its high price and his disinterest in tech stocks.

Top value stocks

Below are some of investors' favorite value stocks

Perhaps the easiest way to screen for value stocks is to search for stocks with low price-to-earnings ratios. The P/E ratio, a favorite among investors, is the most direct way to determine if a stock is cheap as it tells you how much you are paying for each dollar of earnings. For instance, a P/E of 16 means you are paying $16 for $1 dollar of the company's earnings. Using that metric as a guide, below are a few stocks value investors may want to consider.

General Motors (NYSE: GM) shares trade at a P/E of just 5.7 today. The carmaker looks undervalued as the auto cycle has passed its peak, and investors seem skeptical of its ability to continue to grow in a future where electric and autonomous vehicles are ascendant. Instead, investors have favored start-ups like Tesla, which has commanded, at various times, market values greater than GM, despite the Chevy-maker's much greater revenue, profits, and manufacturing assets. Also, considering GM's strong position in autonomous and electric vehicles with its acquisition of Cruise -- an autonomous vehicle technology company -- which sets it up to deploy a ride-hailing service by next year, and its plans to release 20 electric cars by 2023, the company should be a strong player in the future of autos. GM's earnings per share are expected to be flat this year but then return to growth in 2019 as the company releases a new line of high-margin pickup trucks.

Berkshire Hathaway owns shares of GM, and another popular value play the company has snapped up recently is Apple (NASDAQ: AAPL). The iPhone-maker trades at a P/E value of 17.5, still significantly less than the S&P 500 at 24.6. Apple is the most profitable company in the world, generating profits of about $50 billion a year, and it's sitting on an unmatched cash hoard of $285 billion, or $163 billion when subtracting its debt. Deducting the net cash balance gives the stock a P/E of just 14.2. In other words 19% of the company's market value is just the net cash on the balance sheet, so you can subtract that to get the P/E of the business which gets you a P/E of 14.2. Apple is so big and profitable that significant growth has become difficult, but the company still has growing revenue streams like its Services segment, which is made up of things like the App Stores, iTunes, and Apple Pay, and its brand strength -- Interbrand ranks it as the most valuable brand in the world -- as well as its economic moat and cash flow all hold appeal to value investors.

Finally, airline stocks have become attractive to value investors like Buffett, who owns several of them, as the industry has turned profitable after consolidation left four companies in control of 80% of the market. Delta Air Lines (NYSE: DAL) may be the most appealing as it trades at a P/E of just 10.6, offers a dividend, and is poised to grow unit revenue this year after competition pressured it lower over the past two years. The new tax law also looks set to generate windfall profits for the Atlanta-based airline. Buffett said recently that he might buy an airline, and Delta, with its strong market position and cash flow, could make a desirable target.

Is value investing right for you?

As Buffett's record shows, value investing can generate huge returns if executed effectively. However, whether or not you should choose to invest for value may depend most on your investing goals and your time horizon. If you're an older investor looking for wealth preservation and low-risk returns, value investing is a smart choice. Choosing Buffett and Graham stocks that are large, profitable, and sometimes dividend-paying means you're unlikely to experience significant losses, and you should outperform the market if you succeed in finding undervalued stocks.

But value investing and its principles are a smart component to include in any diversified portfolio as a mix of value and growth stocks can help investors get access to big winners but still weather bear markets. Studies have shown that diversification is one of the best ways to lower risk without losing out on returns, and with the power of compound interest, value stocks will deliver over the long term, especially as many offer dividends. While younger investors will probably want to tilt their portfolio toward growth stocks, for any investor, choosing undervalued stocks is a tried-and-true way to beat the market.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Jeremy Bowman owns shares of Apple, General Motors, and Netflix. The Motley Fool owns shares of and recommends Amazon, Apple, Berkshire Hathaway (B shares), Netflix, Tesla, and Walt Disney. The Motley Fool has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.