Want to be a modern treasure hunter? A real-life Indiana Jones, unearthing hidden caches in overlooked locales? Well, here’s an investment strategy for just that, and it’s called value investing. This timeless strategy, practiced by legendary investors like Warren Buffett and Benjamin Graham, is built on a simple yet powerful idea: find companies that are trading for less than their intrinsic value.

You see, to outsiders, the stock market might look like a well-oiled machine. But in reality, there are market inefficiencies and mispricing galore. From the average Joe on main street all the way to the “bigwigs” on Wall Street, traders get things wrong all the time (especially in the short term). Value investors seek to bet on these mispricings before the rest of the market gets its senses back.

For example, during the pandemic, Capital One (COF) traded “below book value” because the market overreacted to loan losses during the pandemic. In March 2020, COF shares were ~$40 a pop. A year later, its price grew to over $150, giving you a cool 275% return.

We saw the same story play out in many industries. Mosaic (MOS) was trading at “low P/E and P/B ratios” in March 2020. You could scoop up MOS at ~$10 per share, as the market underestimated the rebound in fertilizer demand. Two years later, the stock peaked at $76 per share, for a hefty 660% return.

Value investors salivate at these types of opportunities. Now, don’t worry if some of those terms like “book value” or “P/E ratio” went over your head. By the end of this guide, you’ll understand all of this and more. You’ll also be well on your way to finding the next Capital One or Mosaic trade for yourself.

The Core Principles of Value Investing

There are dozens of approaches to value investing, each emphasizing different metrics, techniques, and things to pay attention to. But every successful value investor has internalized three core principles that underpin this entire strategy:

Intrinsic Value vs. Market Price

Imagine you’re at a garage sale and you spot a painting that looks suspiciously like a lost Andy Warhol. The owner thinks it’s just a nice print and is selling it for $50. You, with your keen eye, suspect it might actually be worth a few thousand dollars. In other words, you think its intrinsic value is much higher than its market price.

In the stock market, every company has an intrinsic value – what it’s really worth based on its assets, earnings, growth potential, and other factors. Value investors look for opportunities where the market price of a stock doesn’t reflect this intrinsic value.

For example, intrinsic value and market price can diverge when:

• Investor sentiment or emotions drive prices up or down irrationally
• The market overreacts to temporary setbacks or quarterly results
• Lack of analyst coverage cause smaller companies to be overlooked
• Herd mentality leads to investors blindly following the crowd
• Or a host of other reasons that are more common than you might think!

These types of discrepancies are not overly rare. Some of the most famous (and richest) investors, like Warren Buffett and Mohnish Pabrai, have based their entire approach around this simple idea. Value investors aim to spot that Andy Warhol at a garage sale price.

Margin of Safety

Now, let’s be real – you might be wrong about that painting being a Warhol. That’s why you don’t want to pay $49.99 for it. You want to pay as little as possible to protect yourself in case you’re mistaken. Maybe you haggle with the garage sale owner to get the print at $40. So even if you turn out wrong, and it’s just a regular print rather than an authentic Warhol, you can still offload it later without much loss.

This buffer between what you pay and what you think something is worth? That’s your margin of safety. In value investing, the margin of safety is crucial. It’s the discount between a stock’s intrinsic value and its market price. The bigger the discount, the bigger buffer you have if your calculations are off or if unforeseen problems arise.

Long-Term Perspective

Last but not least, value investing requires patience. Lots of it. You’re not here for a quick flip; you’re here to unearth treasures that others have overlooked. Sometimes, it takes the market a while to recognize the value you’ve spotted, and patience will be your superpower.

Think of it like planting a tree. You don’t dig it up every few months to check on the roots. You plant it, water it, and wait for it to grow. Likewise, once you’ve found an undervalued stock and invested with a good margin of safety, you give it time to reach its full potential.

The stock market in the short term is a voting machine, swayed by popularity and emotions. But in the long term, it’s a weighing machine, reflecting the true value of companies. Your job as a value investor is to buy when the voting machine is undervaluing a stock, and wait for the weighing machine to prove you right.

Four Metrics Every Value Investor Must Know

Financial metrics play a key role in helping value investors screen companies, evaluate them, and compare them against others. While not the be-all end-all, they do tell you at a glance whether a company is worth digging deeper into. There are dozens of metrics you could look at, but these are the four basic ones you must know before you get fancier.

Price-to-Earnings (P/E) Ratio

Imagine you’re buying a vending machine business. Would you rather pay $10,000 for a machine that earns $1,000 a year, or $10,000 for one that earns $2,000 a year? Obviously, the second one! That’s the essence of the P/E ratio.

P/E Ratio = Stock Price / Earnings Per Share (EPS)

The P/E ratio tells you how much you’re paying for each dollar of a company’s earnings. For example, if SampleCo’s stock is trading at $50 per share and its EPS for the last year was $5, the P/E ratio would be 50/5 = 10. This means you’re paying $10 for every $1 of the company’s earnings.

Generally, a lower P/E could mean you’re getting more bang for your buck. A company with a P/E of 10 is considered “cheaper” than one with a P/E of 20, assuming all other factors are equal. You’re basically paying “half price” to get the same earnings.

That said, context is key and different industries have different P/E ranges. For example, tech companies tend to have higher P/E ratios than utility companies because they’re expected to grow much faster. The reverse is also true. If a company has an abnormally low P/E ratio, it could be a warning that the market expects its earnings to plummet.

Price-to-Book (P/B) Ratio

If you’ve ever been to a going-out-of-business sale, you know the thrill of getting $100 worth of stuff for $50. The P/B ratio is the same idea – it compares a company’s market value to its book value.

P/B Ratio = Market Value / Book Value

Market value or “market cap” is the total value of a company’s outstanding shares on the stock market. If SampleCo has 1 million shares outstanding, trading at $50 per share, its market value would be 1,000,000 x 50 = $50 million. Market value factors in expectations of future performance and growth.

Book value is what would theoretically be left if a company sold all its assets and paid off all its debts. It’s based on historical costs rather than future expectations. So if SampleCo has $100 million in assets and $60 million in liabilities, its book value would be 100 – 60 = $40 million.

In this example, SampleCo has a P/B ratio of 50/40 = 1.25.

Generally, the higher this ratio, the more “expensive” a stock is. But there’s an important caveat: book value doesn’t always reflect the true value of a company’s assets. Things like brand value, patents, copyrights, and other forms of IP don’t always appear in full on the balance sheet. So as with all other financial metrics, you should treat P/B ratio as but one piece of a larger puzzle.

Debt-to-Equity Ratio

There are two houses: one is mortgage-free, the other has a massive loan on it. Which one would you rather have? You can think of the debt-to-equity ratio as checking a company’s mortgage. It gives you a peek into the company’s financial structure and potential risks.

D/E Ratio = Total Liabilities / Shareholder Equity

Let’s look at an example. Let’s say SampleCo has total liabilities of $60 million and shareholder equity of $40 million. Its D/E ratio would be 60 / 40 = 1.5. This means that for every dollar of equity, the company has $1.50 of debt. Generally, a lower ratio is better because it indicates a company “owes” less money than it “owns.”

In fact, a very high D/E ratio is often a red flag. It means the company could struggle to pay its debts if business slows down. It also means a large portion of the company’s profits might need to go toward interest payments rather than growing the business. 

However, just as with our other metrics, context matters. Some industries naturally carry more debt than others. Utilities and manufacturers, for instance, have higher D/E ratios because they need to pay for infrastructure and equipment. Also, some level of debt isn’t bad, as companies can use debt to finance growth. It’s a fine balancing act.

Free Cash Flow

Last but not least, let’s talk cash. Imagine you’ve paid all your bills, bought groceries, and even splurged on a nice dinner out. The money left in your wallet? That’s your personal free cash flow. For a company, it works much the same way.

FCF = Operating Cash Flow – Capital Expenditures

Operating cash flow is the cash generated from a company’s normal business operations. Capital expenditures (CapEx) is the money a company spends on buying, maintaining, or improving its fixed assets, such as buildings, vehicles, equipment, or land.

The difference between these two numbers is what the company has left over to pay dividends, buy back stock, pay off debt, or reinvest in the business. In other words, it’s the cash left over to spend on increasing shareholder value.

Why is FCF so important to value investors?

• It’s harder to manipulate. Earnings can be affected by accounting choices. But FCF is a more reliable peek into a company’s financial health.
• It shows real profitability. A company might report positive earnings but negative FCF. So it may look profitable on paper, but it’s not actually generating cash.
• It indicates financial flexibility. Strong FCF gives a company options. It can reinvest in the business, make acquisitions, pay dividends, or buy back stock.
• It indicates resiliency. A strong FCF means more “ammo” to weather economic downturns.

Like our other metrics, FCF isn’t perfect. For example, a company could boost short-term FCF by underinvesting in the business. That’s why it’s important to look at FCF alongside other metrics and qualitative factors.

All these metrics are just tools, not magic wands. They can point you in the right direction, but they don’t tell the whole story. The good news is that you won’t need to guess any of this information. All this data is disclosed in a company’s SEC filings, which in turn makes its way into plenty of easy-to-use stock screeners and analysis tools.

Two Major Pitfalls to Avoid in Value Investing

Value investing is straightforward in concept – buy undervalued stocks and wait for the market to see their true worth. But there are still some sneaky potholes that could trip you up if you’re not careful:

The Value Trap

Imagine you’re analyzing a stock, let’s call it “OldTech Inc.” It looks so cheap that it feels almost too good to be true:

• P/E ratio of 5 (industry average is 15)
• P/B ratio of 0.7 (industry average is 2.2)
• Steady dividend yield of 6%

At first glance, you might think, “Wow, OldTech is crazy undervalued! I should buy as much of this as possible.” But here’s what you might be missing:

• It’s on the decline. OldTech’s revenue has been decreasing by 5% annually for the past five years.
• Its products’ days are limited. Their main product, desktop computers, is losing market share to laptops and tablets.
• It owes too much money. They have a debt-to-equity ratio of 2.5, well above the industry average of 0.8.
• Actually, it owes even more. They have huge unfunded pension liabilities that don’t show up on the balance sheet.

So, what’s really going on? OldTech could be a classic value trap. It’s cheap for a reason – the market believes its business is in terminal decline. If you buy based solely on the attractive valuation ratios, you might end up catching a falling knife.

The stock might continue to get cheaper as the company’s fundamental business deteriorates. Worse, that juicy dividend might get cut if cash flow continues to decline, leading to a sharp drop in the stock price.

To avoid value traps, you need to always ask why a stock is cheap. Is it temporary market pessimism or a fundamental business problem? Is the company’s business model still relevant? Are there any hidden liabilities like pension obligations or potential lawsuits?

Not all cheap stocks are bargains. Sometimes, they’re cheap for valid reasons. To be a real value stock, instead of a value trap, it needs to be cheap because the market got its assessment wrong—not because the company is shoddy.

The Quality vs. Price Balance

Let’s consider two companies in the same industry:

	BargainCo	QualityCorp
P/E Ratio	8	18
P/B Ratio	0.9	3.5
Return on Equity (ROE)	8%	25%
Profit Margin	5%	15%
Market Share	5%	30%

As a value investor, you might be instinctively drawn to BargainCo. It’s much cheaper on both P/E and P/B metrics. But this is where many beginners misstep – overlooking quality for price.

QualityCorp, despite being more “expensive,” might actually be the better investment. Here’s why:

• It’s better at spending money. QualityCorp’s superior ROE means it’s generating more profit for each dollar of shareholder equity.
• It enjoys better margins. The higher profit margin gives QualityCorp more buffer during tough times and more profits to reinvest during good times.
• It’s the market leader. With a 30% market share, QualityCorp likely has stronger brand recognition and economies of scale.

Over time, QualityCorp’s superior business could lead to much better stock performance, even if you’re paying a higher price initially. As Warren Buffett famously said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

To balance quality and price, you should look beyond valuation ratios to assess the quality of the business. Consider metrics like Return on Equity (ROE), profit margins, and market share. These metrics form the company’s competitive advantages or “moat.” And just when building medieval castles, a thicker moat will always be safer in the long run.

Does Value Investing Still Work Today?

In a world of high-frequency trading, meme stocks, and AI-driven robo-advisors, it’s natural to wonder if the old-school approach of value investing still has a place. The answer is yes, but the game has evolved. You can no longer expect to set up some basic screens and expect to find the next Coca-Cola.

Consider this: During the dotcom bubble of the late ’90s, many people declared value investing obsolete. But since that “death” of value investing, this discipline has only gotten stronger. Modern value investors like Seth Klarman, Howard Marks, and Li Lu made their billions well after the dotcom bubble burst.

Today, and we’re seeing history repeat itself with growth stocks grabbing every headline. But value investing is more alive than ever. It just needs updated thinking:

1. A broader definition of value: Today’s value stocks might be growing tech companies that the market has temporarily soured on, not just traditional “cheap” stocks.
2. Understanding intangible assets: In our knowledge-based economy, “intangibles” like brand value, patents, and network effects can be much more valuable than physical assets.
3. Factoring in disruption: A “cheap” stock might be a value trap if its industry is facing technological disruption. The reverse is also true. An “expensive” stock might still be hugely undervalued if the market is not factoring in its true disruptive potential.

Here’s a familiar example: Microsoft in 2011. Trading at a P/E of about 10, many viewed it as a stagnant tech giant past its prime. But value investors who looked deeper saw a company with a strong balance sheet, dominant market position, and an emerging cloud business. Those who bought back then have since seen their investment multiply several times over.

Also, keep in mind that assessing “value” is a potent skill for any investor to add to their arsenal, regardless of their main investment strategy. For example, David Einhorn of Greenlight Capital gained fame for his bold and successful short positions, but he still uses value investing principles to evaluate the companies. Bill Ackman, founder of Pershing Square Capital, is known for activist investing, but he often uses value principles as well. So regardless of whether you decide to make value investing your main strategy or not, you won’t regret learning its basics.

Your First Baby Steps with Value Investing

Like other investment strategies, value investing could be a full-length course. But there are some baby steps you can take right away to get the ball rolling. Here’s how to get started:

Step 1: Choose Your Value Screening Tool

The foundation of your value investing strategy is a reliable stock screener. This tool will help you narrow down your list, track your research, and build your watchlist. Here are some of the top options (no affiliate links):

Finviz (Free basic features, $24.96+ per month for premium)

Finviz is a versatile stock screener with plenty of filters for value investors. The free version is great for beginners, while Elite offers real-time data and backtesting. Its visual charts and heat maps make trend-spotting easy. If you want to mix value criteria with other factors, Finviz is an excellent choice.

GuruFocus (Free basic features, $449+ per year for premium)

GuruFocus is tailored for value investors, offering unique metrics like the GF Value. Their free version provides basic screening, but premium unlocks advanced filters and exclusive research. It’s perfect if you want to follow strategies of famous value investors.

Stock Rover (Free basic features, $79.99+ per year)

Stock Rover offers comprehensive screening and research tools. Its value scoring system helps you identify undervalued stocks quickly. You also get detailed financial statements, portfolio tracking, and fair value estimates. For serious value investors, the depth of analysis can be worth the cost.

Seeking Alpha (Free basic features, $239+ per year for premium)

Seeking Alpha offers solid tools for value investors, including their Quant Ratings. You also get access to a wealth of articles from various contributors. The free version is decent, but premium gives you better filters and exclusive newsletters. It’s great if you like to combine data with diverse market opinions.

Picking the right platform is like choosing a car, so take your time with the decision. The best one depends on your specific value investing approach and how you like to analyze stocks. Many offer free trials of their premium features, so take a few for a spin before you commit.

Step 2: Build Your First Watchlist

Once you’ve chosen your platform, set up a basic value stock screen and build your first watchlist. This will not be your “final” or “perfect” watchlist, so don’t overthink this step. We’re just trying to get the ball rolling, and you can tweak this list at any time.

a) In your chosen platform, set up the stock screener with the following criteria as a starting point. You can tweak and adapt these as you gain more experience, but these serve as a good filter for beginners:

• P/E Ratio: Below industry average
• P/B Ratio: Below 1.5
• Debt-to-Equity Ratio: Below industry average
• Positive Free Cash Flow
• Market Cap: Above $100 million (for better liquidity)

c) Run the screen and aim to build an initial watchlist of 5-10 stocks.

Pro tip: Try to pick stocks in industries that you’re familiar with, or in industries you want to become familiar with. One way to gain an edge in value investing is to build a “circle of competence,” or a particular domain that you’re an expert in. While you don’t need to limit all of your portfolio to that domain, it will help you spot opportunities earlier than others.

Step 3: Research & Analyze Your First Stock

Now that you have a list of potential value stocks, it’s time to dig deeper:

a) Choose a stock from your screener results to analyze further. Which one is the most interesting to you? Did any jump out at you from your initial screen? Start with that one.

b) Start by reading what other analysts have written about the stock. This is a great way to gain a footing as a beginner, as it will teach you the various “angles” for analysis. Make sure you don’t just focus on the analysis itself, but also the thought process behind the analysis.

c) For each stock, you can further review:

• Investor presentation (found in the company’s investor relations portal) <- Start here!
• Latest annual and quarterly reports
• Recent news and press releases
• Basic financial ratios (use the metrics we discussed earlier)
• Competitive position in the industry

Pro tip: Don’t worry if all that sounds overwhelming. You do NOT need to go through everything at the very beginning. Your goal right now is just to learn enough about the stock to form an informed opinion on it. We recommend starting with the company’s investor presentation, which is meant to give you an overview of the company. From there, you can then dig deeper if needed.

d) If your stock research doesn’t have one built in, create a simple spreadsheet to track key information:

• Company Name and Ticker
• Current Price
• Key Metrics (P/E, P/B, D/E, FCF)
• Potential Catalysts for Value Realization (i.e. your “investment thesis”)
• Risks
• Your Estimated Intrinsic Value

And that’s it! You’ve researched your first stock, analyzed its metrics, and formed an investment thesis around it. While value investing can get much fancier, with more advanced metrics, deeper dives into the company’s SEC filings, and incorporating other types of data… you’ve now gotten the hang of the basic research flow. Remember, this is just the beginning. Start small, stay curious, and keep learning.

Pro tip: Another good way to learn as a beginner is to swipe and study the trades of more experienced value investors. For the full guide on this strategy, see Alpha Cloning 101: The Spicy Art of Copycat Investing.

Treasure Awaits: Your Value Investing Journey Begins

With the fundamentals in tow, you’re now ready to start your treasure hunt in the stock market. Value investing is as much an art as it is a science. As you gain experience, there’s a whole world of advanced techniques waiting for you to explore. Here’s a glimpse of what lies ahead:

• Qualitative Analysis: Learn to read between the lines of financial statements, decipher management’s true intentions, and spot potential red flags before they show up in the numbers.
• Moat Evaluation: Learn to identify and assess a company’s moat, especially in new and lesser understood industries.
• Scenario Analysis: Learn to estimate and combine multiple possible outcomes to form a more complete picture of a company’s future.
• Catalyst Identification: Learn to spot hidden catalysts that could unlock a company’s hidden value.
• Combining Growth and Value: Learn to find undervalued companies that also have major growth potential.

One last word of wisdom: as a value investor, you’ll need to cultivate the mental fortitude to go against the crowd. To buy when others are fearful and sell when others are greedy. Are you ready to begin your illustrious journey as a value investor? The market is vast, full of undiscovered treasures waiting to be unearthed, and your toolkit is ready. The only question left is: Where will you start digging?