Value investing
Value investing buys what is cheap relative to earnings, assets or cash flow and waits for the price to reflect fundamentals.
Common measures
| Ratio | Definition | Note |
|---|---|---|
| Price / Earnings | Price per share ÷ earnings per share | Distorted by one-off items |
| Price / Book | Market cap ÷ book equity | Misses intangible assets |
| EV / EBIT | Enterprise value ÷ operating earnings | Accounts for debt |
| Free cash flow yield | Free cash flow ÷ market cap | Hard to manipulate |
History of the premium
Fama and French (1992) documented that cheap stocks by book-to-market outperformed expensive ones over decades. From roughly 2007 to 2020 the effect was weak, partly because intangible-heavy companies look expensive on book value. Many practitioners now combine several metrics and add a quality filter to avoid "value traps", companies that are cheap because their business is in decline.
Margin of safety
Benjamin Graham's central idea: buy only when the price is well below a conservative estimate of intrinsic value, so that an error in the estimate does not turn into a loss.
Further reading
Benjamin Graham, The Intelligent Investor; Joel Greenblatt, The Little Book That Still Beats the Market.
Practice
Three quick tasks. Pick an answer to check it, or open the answer below each task.
Share price 50, earnings per share 5. What is the P/E?
Show answer
10. P/E = 50 / 5 = 10.
What is a value trap?
Show answer
A cheap stock that stays cheap because the business is declining. Cheap for a reason; quality filters help avoid it.
Why can price-to-book mislead today?
Show answer
Book value ignores many intangible assets. Brands, software and R&D are largely missing from book equity.
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