Value Investing

by David Tsai, Marketing Director of UIA

Value Investing

Value investing is the investment method of purchasing securities that are trading below their inherent value. The logic behind the strategy is that by purchasing the securities at a cheap price (relative to earnings or another company fundamental), one can make gains on the investment once the market begins to correctly price the stock. A value investor is interested in stocks that have low stock price ratios in relation to their earnings, dividends, cash flow, and book value.

Enterprise multiple

So how do you know when a certain issue has become undervalued? One handy tool that investors use is the enterprise multiple. It is a simple ratio that allows investors to compare the relative expensiveness or cheapness of a particular stock. Here’s the calculation:

EM = Enterprise Value / EBITDA

This ratio is important in value investing analysis because it allows you to relatively rank stocks based on how expensive they are relative to their earnings power. The enterprise multiple can be used to compare stocks within an industry or to track the relative expensiveness of a stock over time.

While the more widely known P/E ratio is still used, there are distinct differences between the two ratios (which we’ll go into in a later post) that makes the enterprise multiple more accurate in reflecting how expensive a stock is relative to its industry peers.

Intrinsic value

Examining enterprise multiples is useful for comparing the relative expensiveness of securities, but ultimately, your buy or sell decision comes down to whether you believe the stock is trading above or below its intrinsic value and by how much. While there are several methods to accomplish this, one of the most common ways is using Discounted Cash Flow (DCF) analysis. The idea behind this method is that the present value of the company is the sum of all discounted future cash flows attributable to shareholders. If the calculated present value is greater than the current price of a stock, then the stock is undervalued and represents a bargain.

A full explanation of DCF analysis goes beyond the scope of this article, but the EDS Financial Trading & Technology Center of the McCombs School of Business offers several classes on this topic. You can find the next class time by visiting http://www.edscenter.utexas.edu/calendar.asp. Additionally, Investopedia offers a short tutorial at http://www.investopedia.com/university/dcf/ for those who want a quick run-through.

Value Investors Beware

Sometimes investors will misinterpret and abuse the value investors’ mantra of buy low and sell high as an excuse to buy any stock on a downward spiral. A stock whose price is falling precipitously does not instantly become a bargain because it may have been overvalued to begin with. You must first make sure to examine what has caused the price to drop. Is it truly that the security has been oversold beyond its inherent worth? Or has something happened to severely impair the overall value of the company?

The above was just a cursory look at how value investing works. To delve deeper into the strategy, read The Intelligent Investor by Benjamin Graham, considered the bible of value investing.

First Post!

The UIA board is experimenting with blogging for the general UIA members. The blog would contain anything and everything - from market updates and stock-picks to satirical videos. We aim to update it 2-3 times a week - something to give you guys a reason to keep coming back to the site ;) Feel free to leave comments to disagree with the authors, add more points to the argument or complement them.

For today, here's a story of a fired Lehman Brothers' broker:

Remember to keep a lookout for upcoming events: the Kershner Trading visit, the UIA Halloween party and the Investors Open. And just a month more of trading left on the Stock Market Challenge so if you are inching to try some aggressive trading tricks, this may be the best time! (If you haven't registered for it yet, contact the Treasurer, Kunal Patel, asap.)