When we talk about “the most successful investor” Warren Buffett, we are always eager to find out the way he makes his portfolio and select stocks. This man, who’s humorous and smart, often highlights his weapons of mass destruction – value investing.
What is value investing?
Value investing is one of the common methods in securities – particularly in stock market, which usually aims in search of stocks underestimated. Value investors concentrate on PE ratio, book value& some other measures.
One key element: the intrinsic value, if underestimated, the price will surely move upward. Then you figure out that is the very stock you want.
Here we talk bout two models in calculating intrinsic value.
Number one is DCF model.1938, DCF(discounting cash flow ) was introduced in a famous book <Theory of investment value> by American investment theorist , John.B.Williams. This model had been considered as the classic in stock valuation during the following decades. Williams think, people buy stock in order to earn the dividend, future cash flow means dividend in the future to shareholders, therefore the intrinsic value should be equal to present value of expected future dividends.
Number two is DCFM model.
1961, Modigliani& Miller pointed out that dividend was not definitely related to the stock price, based on this they introduced the MM theory. Under some strict assumptions, dividend policies would make no difference to the business value or stock price of a company. After that people created a new concept, free cash flow. The value of stock is equal to the present value of expected FCF (free cash flow).
Another key element is safety of margin, which was considered as the supreme point by Benjamin Graham (guide of Warren Buffett). Suppose you build up your position, you’ll get an average price of cost and expected price as well as present price. The expected price or the present price subtracts the cost price gets the price of safety of margin. In short, underestimation means low lying land, overestimation means risk, just make your operations between low lying land and intrinsic value. That would be best.
Value investment does not shake sharply.
Value investing often used in conventional industries becomes more and more popular in China. The essential of value investment is to buy stocks of those companies which perform well and steady, with huge capital stock. Always invest in those companies you’re familiar with, this keeps you aware of where you are other than lost in new concepts and ocean of data and information. Just like “oracle of Omaha” said, “Racing in wrong direction, the faster the worse it would be going”.