Warren Buffett, the chairman of Berkshire Hathaway, ranks among the exponents of value investing. Here, Haydn Ellwood, director of Yellow Capital, gives a brief introduction to this investment approach.

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return” -  Benjamin Graham

Ben Graham, the father of value investing and the concept of security analysis as we know it today, referred to investing as being “most intelligent when it is most businesslike”. This concept is echoed by Warren Buffet, when he says “a share is an ownership in a company, not just a flashing ticker code on a screen”. To really understand what it is like being a value investor, is to look at investing from an entrepreneur’s perspective. The question to ask is: what do I, as owner of this company receive for buying its equity?

Traditional value investors are typically bottom-up investors. They are not concerned with the greater economic conditions or prospects. They tend to be only looking at companies that are unloved, considered “dogs” and have been discarded or in distress. This system of investing has served many who follow the art exceptionally well. 

Because value investing offers a “margin of safety” and uses normalised average earnings (this is in stark contrast to investment banks/analysts that base valuations on forward “projected earnings”), the ravage effects of cyclicality and secularity can be avoided and ironed out.

The modern value investor

What separates the contemporary value investor is that he/she often uses a top-down approach and often uses both approaches to get a better feel for the company they are valuing.

In this article I aim to provide a broad outline of the steps involved in how to value a company share the Graham way.

First is the search for value, i.e. Where do you look to find value? Searching the universe for a share to value can seem daunting. So where do you start? Here are four filters to narrow down the universe.

·         Low P/E (less than 12x)

·         Low P/B (not more than 1.5x)

·         Small cap

·         Low analyst coverage

Without elaborating on each of the above filters and giving reasons for applying them, let’s just say that most institutional investors are not looking there. This should give you a clue…

Traditional methods of valuation and value investing (valuation) are very similar in most respects except in terms of discounted cash flow, terminal values and growth rates. This article is not intended to discuss the differences but merely to highlight some of them.

Next steps

After the search is complete and a target company has been selected for valuation, the next step is to determine (a) the business risk and (b) the financial risk of the company. Using the two elements above, one would calculate the (B/V) debt to equity ratio and compare it to the target B/V of similar companies in the same sector/industry. This is useful to judge the company’s financial management and efficiency. Once the B/V has been established the (kd) cost of debt can be determined. At this stage it may be useful to calculate the companies Return On Invested Capital (ROIC) as a “back of the cigarette packet” calculation to see if the company is creating or destroying value.

This will be done again at a later stage for confirmation. It is now that the balance sheet is analysed to determine the “asset reproduction value”. This is where the concept of “looking at it from an entrepreneur’s perspective” comes into play. If a new entrant to the market wanted to set up, he would need to replicate the assets already in production of our company being valued. This estimation calculates the asset value of the company, and by removing the liabilities one arrives at the Net Asset Value (NAV).

The next step is to determine the Earnings Power Valuation (EPV) of the company by finding the free cash flows (normalised) attributable to equity holders. As a business owner you are concerned with how much cash the business is producing.

Both steps above are divided by the total issued/called up shares. The following decisions can now be concluded:

(a)    If NAV>EPV – then amongst other things, management are not optimising the assets, or there may be excess capacity in the sector.

(b)   If EPV>NAV – then it is possible that management are operating exceptionally well, or the company may have a competitive advantage.

Further analysis is required in both instances. In (a) there could be potential for a special situation, take-over or an activist approach to change management. In (b) if the competitive advantage is sustainable in the long run (for example Intel), then you have an excellent long term buy and hold opportunity. Coca Cola should be ringing in your ear about now.

Either way, these conclusions do not signal a buy recommendation. To determine a target entry price, it is necessary to subtract the difference between EPV and NAV, and then multiply the difference by a factor of the probability of a catalyst occurring. The sum is then added to the EPV. This figure is then multiplied by two-thirds to find the entry price that resembles the “margin of safety”.

Security analysis is not meant to be exciting or thrilling, nor is it a science. Investing is more about psychology (behavioural finance) than IQ or academics (can the failed US hedge fund Long-Term Capital Management be a better example?).

Investing is an art and a discipline rolled into one. Undervalued securities normally take three to five years to be realised, so don’t worry when the share price stays flat and or depressed for long periods of time.