Definition of value investing
A style of investing developed in the early 1930s at Columbia University by Benjamin Graham (financial strategist), who showed an approach to find and buy stocks at a discount to their intrinsic value, namely to buy stock on sale, or to buy stocks for 50 cents that are worth $1.
To find truly undervalued stocks, value investors follow a three step process. In the first step, they sort stocks by price/earnings (p/e) or other metrics and concentrate on the lowest p/e stocks. This step enables value investors to reduce the number of stocks they will examine more closely and at the same time identify potentially undervalued stocks by focusing on the lowest p/e stocks.
When commentators say value beats growth, they mean the lowest p/e group of stocks returns, on average, more than the highest p/e group. It is because of this, many investors believe the only thing value investors do is sort stocks by p/e and invest in the lowest p/e stocks. However, this is just the first step in the value investing process.
Next, value investors individually value each of the low p/e stocks to find which of the stocks are truly undervalued. A stock may have a low p/e because it is a bad stock. The only way to differentiate the good from the bad is to value all stocks in the low p/e group.
The final step in the value investing process compares the intrinsic value of each stock to the market price. If the stock price is lower than the intrinsic value by more than the so-called “margin of safety” (normally around 33% of the intrinsic value) the stock is considered truly undervalued and it is worth investing in.