Often times, when people go out to buy something, they always think about price, price, price. You know what’s even more important? The value. What value are you truly gaining from what you’re buying? By only thinking about the price of an investment, you leave yourself very vulnerable to making a bad investment. The purpose of this article is to help you develop or expand your mindset to value investing. I will walk you through the approach, how a well-known billionaire is profiting off of this strategy each and every day, and how to apply it in your everyday life.
Warren Buffett is arguably the greatest investor of all time. He’s a well-known billionaire that managed to grow his net worth from $6,000 at the age of 15 to $73.3 billion as of 2016. Mr. Buffett uses a very strategic concept known as value investing, which he learned from Benjamin Graham. Value investing is an investment strategy where stocks are selected that trade for less than their intrinsic values. This simply means you buy a stock at a price below what you think it’s worth, not now, but in the future. According to Investopedia, “the intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors” (“Intrinsic Value Definition | Investopedia”). In more plain English, intrinsic value is how much you believe something is worth. Once again, the focus is not on now, but rather, in the future.
Examples of stocks that are undervalued are stocks with “lower-than-average price-to-book ratios, lower-than-average price-to-earnings ratios and/or higher dividend yields” compared to another similar stock or the industry it operates in. (“Value Investing | Investopedia”) Investors use what’s known as fundamental analysis to evaluate the overall health of a company and ultimately, it helps determine its intrinsic value. Intrinsic value can be made up of many things including, but not limited to, a company’s ability to pay dividends, how much the economy values it, and how profitable it can be. The bottom line is that intrinsic value is very difficult to measure. Ten different investors will probably have ten different intrinsic values for the same company. The discounted cash flow (DCF) model is one commonly used valuation method to determine a company's intrinsic value. The DCF model takes into account a company's free cash flow and weighted average cost of capital, which accounts for the time value of money. This basically means how much the company can make vs. how much it's borrowing.
What Mr. Buffett does is that he buys stocks where the current market price/value is lower than the intrinsic value. To account for any errors, he accounts for a margin of safety, which means that he buys stocks at a big enough discount to allow some room for error in the estimation of value. According to Mr. Buffett: “you should find an outstanding company at a sensible price rather than generic companies at a bargain price” (“Why Value Investing | Capital Discussion”). Apple is a great example of a value stock, but is also a growth stock. It’s very valuable to investors and has potential to grow significantly due to the industry it operates in. Other value stocks include AT&T, General Electric (GE), Microsoft, etc. Intrinsic value can be based on both quantitative and qualitative factors. Ultimately, intrinsic value is based on your own opinion. Keep in mind that value investing doesn’t mean buy cheap stocks. It simply means buy something that has greater value than what you paid for it and now we can talk more about how you can apply it to your daily life.
Daily Life Examples
Although value investing mainly applies to investments such as stocks, there are many different ways you can apply it to your everyday life. Let’s take fast food for example. Fast food is very cheap, but as many of us know, has side effects. You’re trading low cost for low quality in most cases. Although, you’re saving money on the front end, you’re also deteriorating your health. This is a scenario where the price of the investment is actually lower than the value it’s providing. Instead, you can look for slightly costlier options that will prove to be worthy in the future and provide you with good health.
Let’s take another example: buying a home. Those cheap homes look very attractive when you look at the numbers, but are they really worth it? You find a house that costs $25,000, but has property taxes of $15,000 a year in a fairly bad neighborhood vs. a house that costs $150,000, but only has $3,000 in annual property taxes and is in a fabulous neighborhood. Your average individual will probably choose the $25,000 house because it’s cheaper. Clearly, this will most likely cost you in the long-run. Price is important, but value is even more important.
Let’s even look at dating. The type of person you date and the amount of time you spend with that person can have a significant impact on your life. I personally don’t date anyone that I don’t see a future with. So for me to invest time into a woman that I don’t see a future with would prove to be virtually worthless. Clearly, that would be an investment where the price (time) is greater than the value (a successful and long-lasting relationship). Oh yeah, price is not just money, it can be the time you spend as well. Value is not just return on investment, but can be based on your own personal values as well.
Now to a business. One of the biggest fears of any business is competition. A typical business owner will lower his/her prices based on a new competitor entering the market. This can be a smart approach in the short-term, but may be costly in the long-run. The smarter thing to do is to add more value to your customers/clients. Whether it’s better customer service or higher-quality products, you will probably stay in business for a long time if you consistently add value to your clients. It might take a few more trainings. It might take a few more dollars. But so what? Make investments that generate more value. That way you don’t have to lower your prices and you can potentially eliminate the competition. I personally love competition as it forces me to add more value to my clients and ultimately, work harder. It’s also smart to price your services/products based on how much value it brings to your customers.
I hope you will make investments that are more valuable than what you pay for them. Focusing solely on price can hurt you in the long-run. Not everything in life that’s free or cheap is worthy. If Warren Buffett is making billions off this philosophy, then why can’t you? If you have any questions, please don’t hesitate to contact me.
"Intrinsic Value Definition | Investopedia." Investopedia. Web. 15 Dec. 2016.
"Value Investing | Investopedia." Investopedia. Web. 15 Dec. 2016.
"Why Value Investing | Capital Discussion." Capital Discussion. Web. 15 Dec. 2016.