Value Investing Strategy: Key Rules and Insights

Value investing is a time-tested strategy that is a personal favorite of many traders. Even the industry veterans like Warren Buffett have admitted to following the Value Investing strategy. The basic idea of Value Investing involves identifying undervalued stocks and buying them at the most advantageous price. Once the stock has realized its true potential, the investor sells the stock and books the profit.

With the market evolving, the strategy itself has undergone several changes. Even its inventor, Benjamin Graham himself, has made additions to the strategy in the form of additional metrics and formulations to value a stock. Despite the inherent advantages of the Value Investing strategy, a good stock analysis means that an investor is reviewing all metrics, both past and current, while keeping a close watch on the future, where the actual profits lie dormant.

The Graham Method: Timeless Strategies from the “Father of Value Investing”

In his book, The Intelligent Investor, Benjamin Graham, the father of Value Investing, has shown the world how to screen stocks properly, even for relatively new investors who are just beginning their trading journey. This strategy is a great way to build a healthy portfolio. Perhaps one of the most interesting features of this strategy is that it is not overly complicated, meaning that even inexperienced traders can make full use of the strategy.

Under all the technical bells and whistles, the essence of this strategy encompasses an analysis method with which the stock’s true value is determined even before the stock is valued at that price by the market. The beauty of this analysis is that investors or traders can buy such stocks well below their actual worth.

The Quantitative Pillars of Graham’s Value Investing Framework

Value Investing is much more than the often recited slogan of “Buy stocks with a price-to-book (P/B) ratio of less than 1.0.” The P/B ratio is one among the many parameters that Graham uses to identify undervalued stocks. To make matters simple, this article will focus on a condensed version of the famed Value Investing strategy and the three key criteria that make up the strategy.

1. P/B Ratio of 1.0 Or Lower

One of the key criteria to note while entering the stock market armed with Value investing is the P/B Ratio or the Price-to-Book Ratio. This ratio becomes important because it represents the comparison between the company’s share price and its actual assets. While the P/B ratio is an important criterion, it functions properly only when assessing a capital-intensive company. Applying the P/B criterion to a non-capital-intensive company may be erroneous.

2. P/E Ratio or Price-to-Earnings Ratio

What the P/E ratio basically means is how much the market is willing to pay for every dollar worth of profit the company makes. While a low P/E means that the underlying stock is cheap, Graham thinks that the term low itself is relative. A better way to approach the P/E ratio is to follow the P/E to be less than 40% of its 5-year high rule. The benefit of this rule is that it forces an investor to identify a company that is trading at a low price when compared to its most optimistic historical valuation.

3. NCAV Method or Net-Net Investing

This criterion is used to identify “cigar-butt” stocks, companies that are trading for significantly less than their liquidation value. When a trader identifies a stock using the NCAV method of Value Investing, they are essentially buying the business for less than the value of its cash and physical assets, effectively getting the entire ongoing business operations for free. NCAV combines two conditions to work properly.

The first condition is the “Tangible Book Value”. This first condition presented by the rule requires the share price to be less than 67% (two-thirds) of the tangible per-share book value. The importance of this first condition is that it deploys a safety net for trading. By purchasing a stock for two-thirds of its tangible value, an investor is exposed to much less risk.

The second, and more stringent, half of the rule requires the share price to be less than 67% of the Net Current Asset Value (NCAV) per share. NCAV is the value obtained when the total liabilities are subtracted from the company’s current assets. The importance of NCAV lies in its determination of what is truly valuable in all scenarios, so the NCAV focuses only on the most liquid assets—things that can be turned into cash within a year.

Final Thoughts On Graham’s Value Investing

There is a universally accepted number of rules cemented in Value Investing. In the early years, Graham had defined seven specific criteria for the “defensive” (passive) investor in The Intelligent Investor. Later, he added more rules, making the strategy more comprehensive. This is what gave birth to the more stringent set of ten quantitative rules for stock selection.

We have discussed three core rules from the ten quantitative rules. This is just a brush-up on the whole matter of Value Investing. However, the three mentioned rules or criteria are key in determining whether or not a stock is undervalued. By using the three criteria, investors can arrive at a well-defined decision. From there, the rest of the rules can be applied to make sure that the earlier analysis was right or wrong.

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