A

PROJECT REPORT ON
VALUE INVESTING AS AN INVESTING STRATEGY

SUBMITTED TO

SAVITRIBAI PHULE PUNE UNIVERSITY

IN PARTIAL FULFILLMENT OF THREE YEARS DEGREE IN

BACHELOR OF BUSINESS ADMINISTRATION (B.B.A)

SUBMITTED BY
ANIKET KULKARNI
ROLL NO: 37

UNDER THE SUPERVISION OF

Prof. Jayashree Venkatesh
PROJECT GUIDE
THROUGH

NESS WADIA COLLEGE OF COMMERCE, PUNE 411001.

2017-2018

MODERN EDUCATION SOCIETY’S

NESS WADIA COLLEGE OF COMMERCE, Pune

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 Certificate

This is to certify that the project-work titled- “VALUE INVESTING AS AN INVESTMENT

STRATEGY”, has been completed satisfactorily, in partial fulfillment of BBA (SEM VI), course
of The Savitribai Phule, Pune University, for the academic year 2017-18 by Aniket Kulkarni of
Ness Wadia College of Commerce, Pune. Under the supervision of Prof. Jayashree Venkatesh.

INTERNAL EXAMINER EXTERNAL EXAMINER

Prof. Jayashree Venkatesh Prof. Dr. Girija Shankar

Project Supervisor Principal

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 DECLARATION

I Aniket Kulkarni, student of BBA, studying at Ness Wadia College of Commerce, declare that
the project work titled “VALUE INVESTING AS AN INVESTMENT STRATEGY”. A market
research was carried out by me in partial fulfillment of BBA program under the Savitribai Phule
Pune University.

This project was undertaken as a part of my curriculum according to the university rules and
norms and by no commercial interests and motives.

DATE: / /2018 Signature

Place: Pune Aniket Kulkarni

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 ACKNOWLEDGEMENT

I would like to express my sincere thanks to the Savitribai Phule University Pune and Ness Wadia
College of Commerce for giving me the opportunity to prepare and present this report.

“There is a good saying that the work is successfully completed if the person is guided properly at
the right time by the right person”, with that the good opportunities that we receive as well as the
efficient supervision and the most valuable the internal guidance.

Hereby I would like to express my deep gratitude to our PROJECT GUIDE ‘Prof. Jayashree
Venkatesh’. Who in her busy schedule provided us with full support and encouragement, her
whole hearted co-operation throughout the progress and the completion of the project.

I would like to extend my sincere thanks to my teacher and friends for their motivation and direct
and indirect support for completion of this project. Last but not the least I would also like to thank
the respondents for spending their valuable time and knowledge.

By,
Aniket Kulkarni

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CHAPTER NO PARTICULARS Page No
1 INTRODUCTION 8
1.1 BACKGROUND AND CURRENT SCENARIO 9
1.2 NEED FOR STUDY 17
1.3 OBJECTIVE OF THE STUDY 17
1.4 SCOPE AND LIMITATIONS OF THE STUDY 1.2
17
1.5 ORGANISATION OF THE STUDY 18
2 LITERATURE REVIEW 20
2.1 EVIDENCE SUPPORTING VALUE INVESTING 21
2.2 ALTERNATIVE EXPLANATIONS ON THE VALUE PREMIUM 24
2.3 INTERNATIONAL EVIDENCE 27
3 RESEARCH METHEDOLOGY AND DATA ANALYSIS 32
3.1 RESEARCH METHEDOLOGY 33
3.2 DATA ANALYSIS 55
4 THE CONCLUSION 72
4.1 CONCLUSION 73
ALIF GLASS TRADERS
4.2 SUGGESTIONS AND RECOMMENDATIONS 74

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 EXECUTIVE SUMMARY

Since the publication of “The Intelligent Investor” by Benjamin Graham, what is commonly
known as “value investing” has become one of the most widely respected and widely followed
methods of stock picking. Famed investor Warren Buffet, while actually employing a mix of
growth investing and value investing principles, has publicly credited much of his unparalleled
success in the investment world to following Graham’s basic advice in evaluating and selecting
stocks for his portfolio.

Over the years, Graham’s original value investing strategy has been adapted, adjusted, and
augmented in a variety of ways by investors and market analysts aiming to improve on how well
a value investing approach performs for investors. Even Graham himself devised additional
metrics and formulations aimed at more accurately determining the true value of a stock.

In this project, I offer a number of stock valuation approaches and metrics for you to consider
using in order to determine whether a stock’s current price share represents a good “value” buy.
Whenever you evaluate a company and its stock price, you need to interpret the numbers in light
of things such as specific industry and general economic conditions.

In addition, good stock analysis requires that you always review past and current financial
metrics with an eye to the future, projecting how well you think a company will fare moving
forward, given its current finances, assets, liabilities, marketplace position, and plans for
expansion.

Non-numerical “value” factors that investors should not overlook include things such as how
effectively a company’s management is achieving goals, moving the company forward in a way
that is consistent with pursuing its corporate mission statement. A company may be showing
impressive profitability for the moment, but in today’s excessively competitive marketplace, a
company that is not carefully mapping, planning out, and reviewing and when needed, re-routing
its progress will nearly always eventually be eclipsed by a company that is doing those things.

It’s important to note that “value investing” and “growth investing” are not two contradictory or
mutually exclusive approaches to picking stocks. The basic idea of value investing – selecting
currently undervalued stocks that you expect to increase in value in the future – is certainly
focused on expected growth.

The differences between value investing and growth investing strategies tend to be more just a
matter of emphasizing different financial metrics and to some extent a difference in risk
tolerance, with growth investors typically willing to accept higher levels of risk. Ultimately,

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value investing, growth investing, or any other basic stock evaluation approach has the same end
goal: choosing stocks that will provide an investor with the best possible return on investment.

In this research paper we shall study about the methods for screening stocks that Graham
proposed, explained and developed to assist even the most inexperienced investors with their
stock portfolio selections which we shall learn. In fact, that’s one of the major appeals of
Graham’s value investing approach – the fact that it’s not overly intricate or complicated, and
can, therefore, be easily utilized by the average investor.

As with any type of investing strategy, Graham’s value investing strategy involves some basic
concepts that underlie or form the foundation or basis for the strategy. For Graham, a key
concept was that of intrinsic value – specifically, the intrinsic value of a company or its stock.
The essence of value investing is using a stock analysis method to determine the stock’s real
value, with an eye toward buying stocks whose current share price is below its genuine value or
worth.

Value investors are essentially applying the same logic as careful shoppers, in looking to identify
stocks that are “a good buy,” that are selling for a price lower than the real value they represent.
A value investor searches out and snaps up what they determine are undervalued stocks, with the
belief that the market will eventually “correct” the share price to a higher level that more
accurately represents its true value.

Secondary data has been used to gather and analyse information. Various research papers,
articles and books have been used as reference.

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 CHAPTER 1
INTRODUCTION

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1.1 BACKGROUND AND PRESENT SCENARIO

In 1949, Benjamin Graham published a book titled The Intelligent Investor. In this book he lays
the foundation for a structured approach to investing called ‘value investing’. The idea behind
value investing is that a stock market is only efficient in the long run and that a rational investor
can take advantage of overly optimistic or pessimistic valuations on the stock market. In his
book, Graham introduces an imaginary ‘Mr. Market’, which has severe mood swings from one
day to the other. These mood swings correspond with the overall movements of the stock market,
which can sometimes be violent as well.

According to Graham, a value investor should refrain listening to Mr. Market in the decision
making process. Instead, the investor should stick to his or her own analysis and act accordingly.
By systematically selecting those stocks neglected by most investors, the intelligent investor can
consistently outperform the market.

Graham experienced this phenomenon already in the first half of the 20th century. Selecting
stocks based solely on certain valuation metrics doubled stock market return compared to the
Dow Jones index. The value premium was so profound that Graham switched his focus from
individual stocks to a group approach.

When talking about value investing, there are basically two paths one can follow. On one hand
there is the qualitative view on value investing, where the management of a firm, the profit
margin on their products and the growth potential of the market are important as well in making
investment decisions. A true value investor takes into account not only the value of the assets of
a company, but also the earnings power and the growth potential (Greenwald, Kahn, Sonkin, &
van Biema, 2001). The financial literature often takes the quantitative approach to value
investing, reducing the whole concept to a few financial ratios which can easily be calculated for
each company, regardless of the market in which they operate and the growth potential of that
market.

It took some time before the work of Benjamin Graham found support in the financial literature.
Basu (1977) was one of the first to systematically evaluate the relationship between the
price/earnings ratio of a stock and the stock return. After this publication many followed (see
chapter 2). Research on the topic of value investing was expanded to a number of different
financial ratios and international evidence on value investing started to appear. Fama and French
published the article Value versus Growth: The International Evidence (1998), in which they
found a value premium in twelve out of thirteen tested markets. The international evidence on
the value premium was confirmed by many others, as explained in chapter 2.

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Value investing is an investment paradigm which generally involves buying securities that
appear underpriced by some form of fundamental analysis, though it has taken many forms since
its inception. It derives from the ideas on investment that Benjamin Graham and David Dodd
began teaching at Columbia Business School in 1928 and subsequently developed in their 1934
text Security Analysis. As examples, such securities may be stock in public companies that trade
at discounts to book value or tangible book value, have high dividend yields, have low price-to-
earning multiples or have low price-to-book ratios.

High-profile proponents of value investing, including Berkshire Hathaway chairman Warren

Buffett, have argued that the essence of value investing is buying stocks at less than their
intrinsic value. The discount of the market price to the intrinsic value is what Benjamin Graham
called the "margin of safety". The intrinsic value is the discounted value of all future
distributions. However, the future distributions and the appropriate discount rate can only be
assumptions. Graham never recommended using future numbers, only past ones. For the last 25
years, Warren Buffett has taken the value investing concept even further with a focus on "finding
an outstanding company at a sensible price" rather than generic companies at a bargain price.

Graham never used the phrase, "value investing" — the term was coined later to help describe
his ideas and has resulted in significant misinterpretation of his principles, the foremost being
that Graham simply recommended cheap stocks.

Value investing is the strategy of buying stocks trading at prices lesser than their intrinsic values.
People who invest into such stocks are referred to as value investors and they actively seek
stocks that have been undervalued by the market. They believe that market often overreacts to
different news stories, leading to price movements that don’t reflect the actual long-term
fundamentals of the concerned companies, thus providing an investment opportunity to these
investors. As a result, value investors can purchase stocks at lower prices than normal.

Value investing requires a contrarian approach, apart from a long investment horizon. If we look
back at the statistics of the past hundred years, we’ll notice that value investment strategy has
outperformed various index returns across many equity markets.

A major task related to value investing is correctly estimating the intrinsic values of different
stocks. Please note, there is no specific correct intrinsic value when it comes to stocks. Two
investors may place completely different values on a given company even if they’re provided the
exactly same information. This is where the concept of ‘margin of safety’ comes into the picture.
It implies that you purchase stocks at a discount big enough to give you some room for error in
the value estimation.

Furthermore, value investing has a subjective definition, which varies from investor to investor.
While some look only at the current assets/earnings ratio, without placing any value on the
potential future growth of the company, others have entirely different strategies revolving around
the future growth estimates and cash flows. Regardless of the methodologies used, it all boils
down to the ability of buying something at a price lesser than its actual worth.
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Stocks may trade at discounted rates owing to several different factors. Nevertheless, the most
commonly known reason is the short-term profit-related disappointment among investors. Many
a times, such disappointments can also result in strong emotional reactions from the shareholders
who may resultantly, sell all their holdings, fearing further negative results.

Value investors on the other hand recognize and place importance on two important facts. First,
majority of businesses have a long-term perspective of their existence and the actual effect of
such short-term setbacks is negligible on the long-term valuation of the businesses. Second,
value investors recognize the fact that when viewed over the long term, poor profit results get
gradually reversed and strong profit results tend to slow down with the passage of time. This is a
powerful fact, one which is not easily believed by everyone.

Value investing is an art that exploits the irrational behaviour patterns of emotional investors.
Emotion is always a constant feature when it comes to market investments. Even though the
companies on offer may change from one decade to the other, the basic human nature of
investors doesn’t. Fear and greed still have a very strong hold on everyone, just like they did a
hundred years ago.

Value Investing Basics

The strategy of value investing, in simple terms, means buying stocks of companies that the
marketplace has undervalued. The goal is not to invest in no-name companies that haven’t been
recognized for their potential – that falls more in the venue of speculative or penny stock
investing. Value investors typically buy into strong companies that are trading at low prices that
an investor believes don’t reflect the company’s true value. Value investing is all about getting
the best deal, similar to getting a great discount on a designer brand.

When we say that a stock is undervalued, we mean that an analysis of their financial
statements indicates that the price the stock is trading at is lower than it should be, based on the
company’s intrinsic value. This might be indicated by things such as a low price-to-book ratio (a
financial ratio favored by value investors) and a high dividend yield, which represents the
amount in dividends a company pays out each year relative to the price of each share.

The marketplace is not always correct in its valuations and thus stocks often simply trade for less
than their true worth, at least for a period of time. If you pursue a value investing strategy, the
goal is to seek out these undervalued stocks and scoop them up at a favorable price.

Value Investing Long-Term

The value investing strategy is pretty straightforward, but practicing this method is more
involved than you might think, especially when you’re using it as a long-term strategy. It’s
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important to avoid the temptation to try to make fast cash based on flighty market trends. A value
investing strategy is based on buying into strong companies that will maintain their success and
that will eventually have their intrinsic worth recognized by the markets. Warren Buffet, one of
the greatest and most prolific value investors of the century, famously said, “In the short term,
the market is a popularity contest. In the long term, the market is a weighing machine.” Buffet
bases his stock choices on the true potential and stability of a company, looking at the whole of
each company instead of simply looking at an undervalued price tag that the market has assigned
individual shares of the company’s stock. However, he does still prefer to buy stocks he
perceives as “on sale”.

History

Benjamin Graham established value investing along with fellow professor David Dodd.

Value investing was established by Benjamin Graham and David Dodd, both professors
at Columbia Business School and teachers of many famous investors. In Graham's book The
Intelligent Investor, he advocated the important concept of margin of safety — first introduced
in Security Analysis, a 1934 book he co-authored with David Dodd — which calls for an
approach to investing that is focused on purchasing equities at prices less than their intrinsic
values. In terms of picking or screening stocks, he recommended purchasing firms who have
steady profits, are trading at low prices to book value, have low price-to-earnings (P/E) ratios,
and who have relatively low debt.

Further evolution

However, the concept of value (as well as "book value") has evolved significantly since the
1970s. Book value is most useful in industries where most assets are tangible. Intangible assets
such as patents, brands, or goodwill are difficult to quantify, and may not survive the break-up of
a company. When an industry is going through fast technological advancements, the value of its
assets is not easily estimated. Sometimes, the production power of an asset can be significantly
reduced due to competitive disruptive innovation and therefore its value can suffer permanent
impairment. One good example of decreasing asset value is a personal computer. An example of
where book value does not mean much is the service and retail sectors. One modern model of
calculating value is the discounted cash flow model (DCF), where the value of an asset is the
sum of its future cash flows, discounted back to the present.

Value investing performance

Performance of value strategies

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Value investing has proven to be a successful investment strategy. There are several ways to
evaluate its success. One way is to examine the performance of simple value strategies, such as
buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book
ratio stocks. Numerous academics have published studies investigating the effects of buying
value stocks. These studies have consistently found that value stocks outperform growth
stocks and the market as a whole.

Performance of value investors

Simply examining the performance of the best known value investors would not be instructive,
because investors do not become well known unless they are successful. This introduces
a selection bias. A better way to investigate the performance of a group of value investors was
suggested by Warren Buffett, in his May 17, 1984 speech that was published as The
Superinvestors of Graham-and-Doddsville. In this speech, Buffett examined the performance of
those investors who worked at Graham-Newman Corporation and were thus most influenced by
Benjamin Graham. Buffett's conclusion is identical to that of the academic research on simple
value investing strategies—value investing is, on average, successful in the long run.

During about a 25-year period (1965–90), published research and articles in leading journals of
the value ilk were few. Warren Buffett once commented, "You couldn't advance in a finance
department in this country unless you thought that the world was flat.”

Well-known value investors

The Graham-and-Dodd Disciples

Ben Graham's Students

Benjamin Graham is regarded by many to be the father of value investing. Along with David
Dodd, he wrote Security Analysis, first published in 1934. The most lasting contribution of this
book to the field of security analysis was to emphasize the quantifiable aspects of security
analysis (such as the evaluations of earnings and book value) while minimizing the importance
of more qualitative factors such as the quality of a company's management. Graham later
wrote The Intelligent Investor, a book that brought value investing to individual investors. Aside
from Buffett, many of Graham's other students, such as William J. Ruane, Irving Kahn, Walter
Schloss, and Charles Brandes went on to become successful investors in their own right.

Irving Kahn was one of Graham's teaching assistants at Columbia University in the 1930s. He
was a close friend and confidant of Graham's for decades and made research contributions to
Graham's texts Security Analysis, Storage and Stability, World Commodities and World
Currencies and The Intelligent Investor. Kahn was a partner at various finance firms until 1978
when he and his sons, Thomas Graham Kahn and Alan Kahn, started the value investing firm,
Kahn Brothers & Company. Irving Kahn remained chairman of the firm until his death at age
109.

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Walter Schloss was another Graham-and-Dodd disciple. Schloss never had a formal education.
When he was 18, he started working as a runner on Wall Street. He then attended investment
courses taught by Ben Graham at the New York Stock Exchange Institute, and eventually
worked for Graham in the Graham-Newman Partnership. In 1955, he left Graham’s company
and set up his own investment firm, which he ran for nearly 50 years. Walter Schloss was one of
the investors Warren Buffett profiled in his famous Super investors of Graham-and-Doddsville
article.

Christopher H. Browne of Tweedy, Browne was well known for value investing. According to
the Wall Street Journal, Tweedy, Browne was the favorite brokerage firm of Benjamin
Graham during his lifetime; also, the Tweedy, Browne Value Fund and Global Value Fund have
both beat market averages since their inception in 1993. In 2006, Christopher H.
Browne wrote The Little Book of Value Investing in order to teach ordinary investors how to
value invest.

Peter Cundill was a well-known Canadian value investor who followed the Graham teachings.
His flagship Cundill Value Fund allowed Canadian investors access to fund management
according to the strict principles of Graham and Dodd. Warren Buffett had indicated that Cundill
had the credentials he's looking for in a chief investment officer.

Warren Buffett & Charlie Munger

Graham's most famous student, however, is Warren Buffett, who ran successful investing
partnerships before closing them in 1969 to focus on running Berkshire Hathaway. Charlie
Munger joined Buffett at Berkshire Hathaway in the 1970s and has since worked as Vice
Chairman of the company. Buffett has credited Munger with encouraging him to focus on long-
term sustainable growth rather than on simply the valuation of current cash flows or assets.

Other Columbia Business School Value Investors

Columbia Business School has played a significant role in shaping the principles of the Value
Investor, with professors and students making their mark on history and on each other. Ben
Graham’s book, The Intelligent Investor, was Warren Buffett’s bible and he referred to it as "the
greatest book on investing ever written.” A young Warren Buffett studied under Ben Graham,
took his course and worked for his small investment firm, Graham Newman, from 1954 to 1956.
Twenty years after Ben Graham, Roger Murray arrived and taught value investing to a young
student named Mario Gabelli. About a decade or so later, Bruce Greenwald arrived and produced
his own protégés, including Paul Sonkin—just as Ben Graham had Buffett as a protégé, and
Roger Murray had Gabelli.

Mutual Series and Franklin Templeton Disciples

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Mutual Series has a well-known reputation of producing top value managers and analysts in this
modern era. This tradition stems from two individuals: Max Heine, founder of the well regarded
value investment firm Mutual Shares fund in 1949 and his protégé legendary value
investor Michael F. Price. Mutual Series was sold to Franklin Templeton Investments in 1996.
The disciples of Heine and Price quietly practice value investing at some of the most successful
investment firms in the country. Franklin Templeton Investments takes its name from Sir John
Templeton, another contrarian value oriented investor.

Seth Klarman, a Mutual Series alum, is the founder and president of The Baupost Group, a
Boston-based private investment partnership, and author of Margin of Safety, Risk Averse
Investing Strategies for the Thoughtful Investor, which since has become a value investing
classic. Now out of print, Margin of Safety has sold on Amazon for $1,200 and eBay for $2,000.

Other Value Investors

Laurence Tisch, who led Loews Corporation with his brother, Robert Tisch, for more than half a
century, also embraced value investing. Shortly after his death in 2003 at age 80, Fortune wrote,
“Larry Tisch was the ultimate value investor. He was a brilliant contrarian: He saw value where
other investors didn't -- and he was usually right.” By 2012, Loews Corporation, which continues
to follow the principles of value investing, had revenues of $14.6 billion and assets of more than
$75 billion.

Michael Larson is the Chief Investment Officer of Cascade Investment, which is the investment
vehicle for the Bill & Melinda Gates Foundation and the Gates personal fortune. Cascade is a
diversified investment shop established in 1994 by Gates and Larson. Larson graduated
from Claremont McKenna College in 1980 and the Booth School of Business at the University
of Chicago in 1981. Larson is a well known value investor but his specific investment and
diversification strategies are not known. Larson has consistently outperformed the market since
the establishment of Cascade and has rivaled or outperformed Berkshire Hathaway's returns as
well as other funds based on the value investing strategy.

Martin J. Whitman is another well-regarded value investor. His approach is called safe-and-
cheap, which was hitherto referred to as financial-integrity approach. Martin Whitman focuses
on acquiring common shares of companies with extremely strong financial position at a price
reflecting meaningful discount to the estimated NAV of the company concerned. Whitman
believes it is ill-advised for investors to pay much attention to the trend of macro-factors (like
employment, movement of interest rate, GDP, etc.) because they are not as important and
attempts to predict their movement are almost always futile. Whitman's letters to shareholders of
his Third Avenue Value Fund (TAVF) are considered valuable resources "for investors to pirate
good ideas" by Joel Greenblatt in his book on special-situation investment You Can Be a Stock
Market Genius.

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Joel Greenblatt achieved annual returns at the hedge fund Gotham Capital of over 50% per year
for 10 years from 1985 to 1995 before closing the fund and returning his investors' money. He is
known for investing in special situations such as spin-offs, mergers, and divestitures.

Charles de Vaulx and Jean-Marie Eveillard are well known global value managers. For a time,
these two were paired up at the First Eagle Funds, compiling an enviable track record of risk-
adjusted outperformance. For example, Morningstar designated them the 2001 "International
Stock Manager of the Year" and de Vaulx earned second place from Morningstar for 2006.
Eveillard is known for his Bloomberg appearances where he insists that securities investors
never use margin or leverage. The point made is that margin should be considered the anathema
of value investing, since a negative price move could prematurely force a sale. In contrast, a
value investor must be able and willing to be patient for the rest of the market to recognize and
correct whatever pricing issue created the momentary value. Eveillard correctly labels the use of
margin or leverage as speculation, the opposite of value investing.

Other notable value investors include: Mason Hawkins, Whitney Tilson, Mohnish Pabrai, Li
Lu, Guy Spier and Tom Gayner who manages the investment portfolio of Markel Insurance.

Criticisms

Value stocks do not always beat growth stocks, as demonstrated in the late 1990s. Moreover,
when value stocks perform well, it may not mean that the market is inefficient, though it may
imply that value stocks are simply riskier and thus require greater returns. Furthermore, Foye and
Mramor (2016) find that country-specific factors have a strong influence on measures of value
(such as the book-to-market ratio) this leads them to conclude that the reasons why value stocks
outperform are country-specific.

An issue with buying shares in a bear market is that despite appearing undervalued at one time,
prices can still drop along with the market. Conversely, an issue with not buying shares in a bull
market is that despite appearing overvalued at one time, prices can still rise along with the
market.

Also, one of the biggest criticisms of price centric Value Investing is that an emphasis on low
prices (and recently depressed prices) regularly misleads retail investors; because fundamentally
low (and recently depressed) prices often represent a fundamentally sound difference (or change)
in a company's relative financial health. To that end, Warren Buffett has regularly emphasized
that "it's far better to buy a wonderful company at a fair price, than to buy a fair company at a
wonderful price."

In 2002, Stanford accounting professor Joseph Piotroski developed the "F-Score", which
discriminates higher potential members within a class of value candidates. The F-Score aims to
discover additional value from signals in a firm's series of annual financial statements, after
initial screening of static measures like book-to-market value. The F-Score formula inputs
financial statements and awards points for meeting predetermined criteria. Piotroski
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retrospectively analyzed a class of high book-to-market stocks in the period 1976-1996, and
demonstrated that high F-Score selections increased returns by 7.5% annually versus the class as
a whole. The American Association of Individual Investors examined 56 screening methods in a
retrospective analysis of the financial crisis of 2008, and found that only F-Score produced
positive results.

Another issue is the method of calculating the "intrinsic value". Some analysts believe that two
investors can analyze the same information and reach different conclusions regarding the
intrinsic value of the company, and that there is no systematic or standard way to value a stock.
In other words, a value investing strategy can only be considered successful if it delivers excess
returns after allowing for the risk involved, where risk may be defined in many different ways,
including market risk, multi-factor models or idiosyncratic risk.

1.2 NEED FOR STUDY

The purpose of conducting this research paper is to study the performance of growth stocks and
values stocks in international markets with a major focus on United States of America and India.
More specifically, it studies the performance of the various stocks for both value and growth
portfolios. In this research paper, I will intend to examine whether value investing has generated
superior returns by adopting various methodologies by previous researchers as to study the
consistency of results obtained by others in relation to International capital markets. This study
will represent an up to date look at the efficient markets hypothesis and to identify whether value
investing is indeed a superior strategy.

1.3 OBJECTIVES OF THE STUDY

The impact of my results would also have direct effects for stock analysts and also individual
investors who are commonly known incline to make forecasts on the international stock markets.
This would make any value stocks over-reaction not likely to occur as compared to growth stock
over-reaction. Lastly, my research project result would be useful to potential and existing
researchers whose interests are in international comparisons between value investing and growth
investing.

1.4 SCOPE AND LIMITATIONS OF THE STUDY

SCOPE

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The performance of the portfolio will cover from the time span of the year 2000 to 2017
involving public listed companies in United States of America and an overall view of Indian and
International capital markets. The companies will be formed as a portfolio prior to evaluating the
post performance. The post performance of the portfolio will then be evaluated using multiple
measures to determine the existence of value premium in International markets.

LIMITATIONS

While this research confirms the existence of a value premium on the international stock markets
using a wide variety of financial indicators, there are some limitations to consider. One of them
is the Worldscope database, which is far from complete. Before the year 2003, the number of
samples with missing data is substantial. While the effect of the dividend yield has been
measured, the sample rate is too low to effectively measure the value premium of this indicator.

Another factor not included in this portfolio analysis is the impact of transaction costs. While the
hypothetical value investing strategies used for this research could be profitable on paper, it
could be unprofitable when applied in real life. Rebalancing a portfolio of many stocks brings
about high transaction costs. An investor could consider reducing the transaction costs by
increasing the holding period from one year to two years.

1.5 ORGANISATION OF STUDY

Chapter one: Introduction
This chapter presents the background information, the objectives of the study, research
questions, significant of the study, and justification of the study.
Chapter two: Literature Review
This chapter presents the theoretical foundation of value and growth investing, previous
researchers done on the topic from the West to East countries, the methodologies adopted to
evaluate post-performance of the portfolio and understanding previous researchers‟ rationale of
the outcome of their evaluations.
Chapter three: Methodology
This chapter discusses and explains the research framework, research methodology responding to
the research design, source of data, sampling and data collection, and measurement of research
variables, which applies in this study.
Chapter four: Data Analysis and Results

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The data analysis is presented in this chapter, including a summary of the results, the analysis of
the measurements used, the performance of value and growth investment analysis and
interpretation.
Chapter five: Conclusion and Recommendation
This chapter covers the managerial implications, conclusion, recommendation, limitation of the
study, and the suggestions for further study presented in this chapter.

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 CHAPTER 2
LITERATURE REVIEW

Page | 20
In this chapter we summarize the findings in the literature on the topic of value investing. First
we will present literature confirming the existence of the value premium. After that we will also
discuss literature questioning this phenomenon. Finally, we will discuss the international
evidence, referring to scientific research performed in foreign markets.

“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an
easily-understandable business whose earnings are virtually certain to be materially higher five,
ten and twenty years from now. Over time, you will find only a few companies that meet these
standards - so when you see one that qualifies, you should buy a meaningful amount of stock.
You must also resist the temptation to stray from your guidelines: If you aren't willing to own a
stock for ten years, don't even think about owning it for ten minutes. Put together a portfolio of
companies whose aggregate earnings march upward over the years, and so also will the
portfolio's market value.” –Warren Buffett (1996 Letter to Shareholders)

2.1 Evidence Supporting Value Investing

Value investing is an investment strategy based on the assumption that stocks move back and
forth between undervaluation and over valuation. Over the years, many types of stock market in
efficiency has been found and documented in the financial literature.

Irrationality
Rozeff and Kinney (1976) made a case in support of a pattern called ‘stock market seasonality’,
where they found stock returns to be higher in January compared to any other month. Same
events were observed by Haugen and Lakonishok (1988) in their book titled ‘The Incredible
January Effect’. An efficient market of rational investors would level out such anomalies, because
investors would spot the irregularity and act accordingly to make excess returns. Over time, the
arbitrage effect would make the anomaly disappear.

A similar anomaly in the stock market was found by Gibbons and Hess (1981) and French
(1980) around stock market movements on Mondays. The so called ‘Monday Effect’ appeared
after studying the daily stock market returns from 1962 till 1978. On average the Monday
returns were clearly negative on average ,with a significant margin of error. The markets

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apparently didn’t see this anomaly during that long period or simply failed to arbitrage it. The
data from 1970 till 1978 showed a decrease of the Monday effect, which however confirms
some arbitrage in the markets. Research by Lakonishok and Smidt (1988) found statistical
evidence for patterns in the stock market sat the end of each month, while Ariel(1990)found
anomalies around holidays.

While these anomalies are not the main focus of this research, they support the assumption that
investors do not always make rational decisions based on the information that is available to
them.

DeBondt and Thaler (1985) and Kahneman & Tversky (1982) show that investors are prone to
human properties like overconfidence in their ability to forecast the market movements and
waves of optimism and pessimism which causes the stock market to overreact. These findings
made a case for an ewcontrarian investment strategy, buying those stocks that are out off a vor
and selling or shorting the ones which are popular.

The research on contrarian investments strategies is somewhat related to research on the value
premium. A value investor selects stocks which are undervalued based on certain financial
ratios such as price to earnings, price to cash flow and price to book value. By systematically
selection stocks based on their financial ratio, the value investor expects to achieve a risk
adjusted return superior to the stock market index. Grahamand Dodd referred to this approach
in their book Security Analysis(1934).

The value premium

The value premium refers to the spread in return between stocks with alow and stocks with a
high valuation, where the excess return cannot(fully) be attributed to additional risk. Investment
managers classify stocks with a high book value compared to market value (B/M), a low
price/earnings ratio (P/E) or a high cash flow yield (CF) as value stocks. Stocks which offer a
high return on assets (ROA) or return on invested capital (ROIC) can also be considered value
stocks, because they can be bought at a relatively low price compared to their performance.

The idea that selecting stocks based on these properties could reward an investor with higher
returns attracted a lot of attention among academics. The first papers on this subject appeared

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decades after the publication of Security Analysis and The Intelligent Investor. Basu (1977)
found a relationship between the price/earnings ratio and stock performance, while Capaul,
Rowley and Sharpe (1993) and Chan, Hamao and Lakonishok(1991) documented a strong
relationship between the book value to market value and stock return. Bauman, Conover and
Miller(1998) and Fama and French (1998) both performed a cross-country study and came to
the conclusion that value stocks outperform growth stocks in almost every country.
Unfortunately both articles do not explain why the results are not in favor of value investing in
all countries. Baumanet al. tested the value premium using both P/ E and the P/ Bindicator,
while Fama and French tested only for the P/Bindicator.

According to Lakonishok et al. (1994) and Haugen (1995) the value premium arises because the
market undervalues distressed stocks and overvalues growth stocks. Over time, these errors are
corrected, resulting in a lower expected return for growth stocks and a higher expected return
for value stocks.

The international evidence was tested again by Spyrou and Kassimatis (2009). Their research
shows the existence of a value premium in European markets. This premium however can be
attributed to a few years of very high returns: for the majority of the sample years the value
premium is indistinguishable from zero in most markets, while for certain markets the HML is
statistically significant for only 20% of the sample period.

HML stands for ‘high minus low’ and is part of the three factor asset pricing model of Fama
and French. Basically HML is the term used to describe the spread in returns between stocks
with a high and low book-to-market ratio.

Arshanapalli, Coggin and Doukas (1998) analyzed stock returns in 18 different equity markets
from four different regions. Using data from 1975 till 1995 they found a substantial difference
in return between low and high book-to-market stocks in 17 out of 18 markets. Fama and
French (2012) also performed a new study on the international value premium. They found
common patterns in average returns in developed markets, echoing results from earlier studies
on the international value premium. Fama and French found a value premium in average returns
in all four regions examined (North America, Europe, Japan, and Asia Pacific).

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2.2 Alternative explanations on the value premium

While many articles show a value premium, there was some criticism on the research
methodology early on. According to Banz (1981), Reinganum (1980) and Stattman (1980),the
value premium is more related to firm size than to indicators as the P/E ratio and the price to book
value. In their research, they found a stronger relationship between stock performance and size
than between stock performance and their financialratios.

Banz (1981) tested the value premium on a larger time period from 1926 till 1975. He also found a
strong value premium, but noted that some of this premium could be explained by firm size. After
analyzing stock market data from the NYSE, he found small stocks to outperform large stocks.
The results were significant, because they could not be explained solely by volatility risk using the
Capital Assets Pricing Model.

The model of Klein and Bawa (1977) gives us a possible explanation of the firm size effect. In
their model, they state that many investors do not want to hold stocks of small companies, because
of the limited availability of information on the stock. Risk averse investors prefer to invest in
those securities which have the most information. The limited diversification among large
investors could be the reason why small stocks outperform large stocks. The demand for small
stocks is lower, which means there are less bids for these stocks in the market. Once the market
recognizes the true value of a stock, the price rises. The financial indicators such as the
price/earnings ratio and the ratio of book value to market value could be just the results of this.

Fama and French (1996) built a three factor risk-return model, in which they incorporate both the
size effect and the book-to-market ratio to isolate the value premium. Using their model, they were
able to fully explain the value premium, including the size factor. Criticism on value investing is
that the superior performance is related to the selection of stocks which carry higher risk in terms
of volatility.

Risk
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When you make the assumption that the value premium is indeed strongly related to firm size, it is
useful to analyze the differences between small and large stocks as well. Chan and Chen (1991)
performed an analysis using NYSE data and found out there is risk involved in buying stocks from
firms with a small market cap. They argue that small firms, at least on the NYSE, tend to be firms
which are less efficiently run and have higher financial leverage. Because of this, small firms
could also have more trouble getting access to external financing. Therefore, the author concluded
that the additional return on small stocks is largely a compensation for the additional risk for the
investor.

Another study published by Chen and Zhang(1998) confirms the importance of the risk factor in
value investing. They built a model measuring risk as the amount of volatility of a stock and
applied it to six different countries. The result soft heir research shows that the value premium can
be captured once dividend cuts, financial leverage and the standard deviation of returns are
included in the equation. The authors conclude that value stocks do indeed outperform growth
stocks in most markets, but that the premium is largely explained by additional risk regarding
stock volatility.

However, most of the literature on value investing implies that the value premium is at best only
partially explained by tolerating additional risk. Basu (1977) concluded that value stock portfolios
performed better on both an absolute and a risk-adjusted basis than a portfolio based on growth
stocks. Reinganum (1980), Lakonishok et al. (1994), Arshanapalli et al. (1998), Fama and French
(1998) and Kwag and Lee (2006) all concluded that the additional performance of the value stocks
over glamour stocks could not or only partially be explained by taking on additional risk, where
risk is defined as the beta (volatility) of individual stocks.

Risk is not always defined as volatility. Warren Buffett defines risk as the reasoned probability of
an investment losing purchasing power. From an article in Fortune: “Assets can fluctuate greatly in
price and not be risky as long as they are reasonably certain to deliver increased purchasing power
over their holding period. And as we will see, a non-fluctuating asset can be laden with risk”
(Buffett, 2012).

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Breen and Korajczyk(1994) tested whether selection bias could impact the results when using
NYSE/AMEX data. In their research they couldn’t find a problem comparing this data with the
Compustat database. Kothari, Schanken and Sloan (1995) conclude that firms reporting extreme
earnings increases are more likely to have a higher book-to- market value ratio. Their research
suggests a small portion of the drift could be attributed to Compustat selection bias.

Chan, Jegadeesh and Lakonishok (1995) examined the potential bias using both the Compustat
and CRSP databases. In their article "Evaluating the performance of value versus glamour stocks:
The impact of selection bias", the authors take a critical look at the way stock returns are being
examined for both value stocks and growth stocks.

Despite the warnings posed by Breen and Korajczyk (1994), research by Kothari, Schanken and
Sloan(1995)and Chan, Jegadeesh and Lakonishok(1995)shows that the impact of selection bias -
based on discrepancies between Compustat and CRSP - is exaggerated.

They conclude that while there is a slight difference between the average P/E of stocks that are
present and missing in the Compustat database, it is too small to question the large amount of
evidence supporting the value premium. From all the missing data on the Compustat database,
only a small number of stocks was in a financially distressed situation.

Chan et al. (1995) conclude that future research on the value premium should clearly document
the potential for selection bias in the sample used. Future research should also mention the
proportion of company years not found in the database on which the conclusions are drawn.

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2.3 International Evidence

Table at the end of this section provides an overview of the international evidence on value
investing using the EBSCO database for articles with the term “value growth” published in
academic journals.

Based on the vast amount of research on the international value investing premium we can conclude
that the premium is not limited to a specific geographic region. The premium doesn’t seem to fade
away overtime, as the results were consistently in favor of the value investing approach between
1970 and 2011.

With the exception of Turkey, Brazil, Taiwan, Thailand, the value investing strategy does deliver
superior returns compared to the market index. While results vary from one indicator to the other, the
consensus is that selecting stocks based on these indicators can help investors around the world to
enhance their portfolio return.
Let’s take a look at the international evidence on the value premium. The articles selected in this
literature review all compare the results of a specific stock market portfolio with the market in
general. The selected articles all apply the same methodology of rebalancing the stock portfolio after
a while. Using this approach, it is possible to compare the results between countries and in different
time periods. In most cases it is set at one year, but some authors look at the value premium over two
or three year holding period.

In most studies, the value stocks are selected based on their book-to-market ratio, which is the ratio
between the market value of a stock and the book value of the assets of the underlying business.
Others incorporate additional ratios, such as price-to-earnings (P/E), the cash flow yield(CF) and the
dividend yield(DY). A number of articles also test the effect of firm size on stock return, to test
whether the outperformance can be attributed to size rather than the value indicator itself.

The table below presents a selection of articles on value investing in a variety of stock markets
around the world. These articles were collected from the EBSCO database after searching for the
keywords “value growth” and were published in a scientific journal. They cover the period from
1970 till 2011 and provide a general view on the performance of value investing. All studies were
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based on building portfolios from stocks, ranked on a number of financial indicators: B/M=book
value to market value, P/B=price to book value, P/E=price to earnings, P/CF=price to cash flow,
P/S=price to sales, DY = dividend yield.

Author Year Research area Period Indicators Conclusion

(geographic)

Chan, Lakonishok 1991 Japan 1971- B/M , P/E , Value stocks outperform
1988 P/CF growth stocks, but the

B/M ratio and cash flow yield

are stronger indicators than
the P/E indicator.

Capaul, Rowley, 1993 France, Germany, 1981- P/B Value stocks provided superior
Sharpe Switzerland, UK, 1992 risk-adjusted performance in
Japan, US each of the researched
countries. However, it is not
clear what causes

the outperformance.

Arshanapalli, 1998 US, Canada, Austria, 1975-
Coggins, Doukas Belgium, Denmark, 1995
France, Germany, UK,
Netherlands, Norway,
Spain, Sweden,
Switzerland, Australia,
Hong Kong, Japan,
Malaysia,
B/M The results show the
superiority of value stocks
compared to growth stocks
during the period 1975 till
1995. Size and book-to market
ratio both have a predictive
value in future returns.

Singapore

Chen, Zhang 1998 US, Japan, Hong Kong, 1970- B/M , DY , Strong value stock effects
Malaysia, Taiwan and 1993 persist in the U.S, but Japan,
Size
Thailand Hong and Malaysia markets
show less value investing
advantage. In Taiwan and
Thailand the benefits of value
investing are undetectable.

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Bauman, Conover, 1998 Australia, Austria, 1985- B/M , P/E , Value stocks generally
Miller Belgium, Canada, 1996 P/CF , DY outperform growth stocks, but
Denmark, Finland, in some years value stocks did
France, Germany, underperform.
Hong Kong, Italy,
Japan, Malaysia,
Netherlands, Norway,
Singapore, Spain,
Sweden,

Switzerland, UK

Fama, French 1998 US, Japan, UK, France, 1974- B/M , P/E , Value stocks tend to have
Germany, Italy, 1994 P/CF , DY higher returns than growth
Netherlands, Belgium, stocks in markets around the
Switzerland, Sweden, world for each of the
Australia, mentioned indicators

Hong Kong, Singapore

Levis, Liodakis 1999 United Kingdom 1968- B/M Value stocks did outperform
1997 growth stocks

Gonenc, Karan 2003 Turkey 1993- B/M, size There is no value premium on
1998 the Istanbul Stock Exchange.
Neither value nor growth

stocks manage to outperform

the market

Wang 2004 China 1994- B/M, size Small stocks outperform

2000 large stocks and value
stocks outperform growth
stocks.

Yen, Sun, Yan 2004 Singapore 1975- B/M,P/E, Value stocks outperform
1997 P/CF growth stocks based on each
of these indicators

Truong 2009 New Zealand 1997- P/E The value premium based
2007 on the P/E ratio is persistent
and could not fully be
attributed to risk.

Michou 2009 United Kingdom 1975- B/M , Size The value spread is not a
2006 good predictor of stock
returns. There is some
Page | 29
 predictive power among
small stocks, but none
among large Stocks

Spyrou, 2009 Austria, Denmark, 1982- B/M The value premium is strong
Kassimatis France, Germany, 2005 on average, but the
Greece, Ireland, Italy, outperformance of value
Netherlands, Spain, stocks is significant only in
Sweden, a few occasions

Switzerland, UK

Athanassakos 2009 Canada 1985- P/E , P/B A value strategy beats a

2005 growth strategy. Forming
portfolios based on the
value investing approach
can help investors to
achieve superior long-term
performance.

Arisoy 2010 France 1997- B/M,P/E, The value stocks outperform

2007 P/CF ,DY growth stocks in Good
times, but they lose more
during bad times

Sareewiwatthana 2011 Thailand 1996- P/B , P/E , The value portfolios

2010 DY significantly outperformed
growth portfolios on the
Thailand stock market.

Huang 2011 Taiwan 1985- B/M,P/E, The value premium is

2009 P/CF ,DY significantly positive

Deb 2012 India 1996- P/B Value stocks outperform

2010 growth stocks during the
major part of the study
period. The value premium
was most visible with the 2
to 5 year holding period

Brailsford, Gaunt, 2012 Australia 1982- B/M , Size There is a systemic value
O’Brien 2006 premium across all size
categories

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Fama, French 2012 North America, Europa, 1989- B/M , Size Value premiums were found in
Japan (23 countries, 2011 each of the four regions.
not specifically When taking size into account,
mentioned) the value premium is larger for
small stocks in all countries
except Japan.

Huang, Yang, Zhang 2013 China 1997- B/M , Size Value premium does exist in
2008 the Chinese stock market

Gharghori, 2013 Australia 1992- B/M , P/S , P/E A strong value premium exists
Strykowski, 2009 , P/CF, on the Australian stock
Veeraraghavan market. Both book to market
Size value and Cashflow to price
are strong

indicators of value premium.

Kyriazis, Christou 2013 Greece 2003- P/E,B/M,DY Value investing strategies

2008 based on each of these three
indicators achieved superior
stock performance.

Cordero, 2013 Brazil 1995- B/M , P/CF , The long-term evidence favors
Machado 2008 growth stocks more than value
P/E , Size stocks. The value premium is
absent in Brazil based on B/M
and Cashflow/price ratios.

Table : International Evidence on Value Investing

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 CHAPTER 3
RESEARCH METHODOLOGY AND DATA ANALYSIS

Page | 32
3.1 RESEARCH METHODOLOGY

Graham’s Basic Value Investing Approach

Graham’s approach to value investing was geared toward developing a simple process for stock
screening that the average investor could easily utilize. Overall, he did manage to keep things
fairly simple, but on the other hand, classic value investing is a little more involved than just the
often-recited refrain of, “Buy stocks with a price-to-book (P/B) ratio of less than 1.0.”

The P/B ratio guideline for identifying undervalued stocks is, in fact, only one of a number of
criteria which Graham used to help him identify undervalued stocks. There’s some argument
among value investing aficionados as to whether one is supposed to use a 10-point criteria
checklist that Graham created, a longer 17-point checklist, a distillation of either of the criteria
lists that usually appears in the form of a four- or five-point checklist, or one or the other of a
couple of single criterion stock selection methods that Graham also advocated.

Graham’s Original Checklist

Here is the original checklist consisting of ten items.

1. An earnings-to-price yield at least twice the AAA bond rate

2. P/E ratio less than 40% of the highest P/E ratio the stock had over the past 5 years

3. Dividend yield of at least 2/3 the AAA bond yield

4. Stock price below 2/3 of tangible book value per share

5. Stock price below 2/3 of Net Current Asset Value (NCAV)

6. Total debt less than book value

7. Current ratio great than 2

8. Total debt less than 2 times Net Current Asset Value (NCAV)

9. Earnings growth of prior 10 years at least at a 7% annual compound rate

10. Stability of growth of earnings in that no more than 2 declines of 5% or more in year end
earnings in the prior 10 years are permissible

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 He introduced the first formula at age 79 and concluded from his results that one would have
performed quite well from 1961-1976 by buying stocks with the lowest values of these three
criteria:
▪ A low multiple (e.g.,10) of the preceding year’s earnings;
▪ A price equal to half the previous market high (“to indicate that there has been considerable
shrinkage”);
▪ Net Asset Value.
In his next interview published in Medical Economics, September 20, 1976 titled “The Simplest
Way to Select Bargain Stocks” Graham, then 82, proposed a simpler, more refined formula that
consisted of:
▪ PE Ratio of 7x-10x or less (Based on 2x current AAA bond rates)*;
▪ [Equity/Asset Ratio of .5 or more (e.g. Debt/Equity <1)].

Summarized view of Graham’s Checklist

1) A value stock should have P/B ratio of 1.0 or lower; the P/B ratio is important because it
represents a comparison of the share price to a company’s assets. One major limitation of the P/B
ratio is that it functions best when used to assess capital-intensive companies, but is less effective
when applied to non-capital-intensive firms.

Note: Rather than looking for an absolute P/B ratio lower than 1.0, investors may simply look for
companies with a P/B ratio that is relatively lower than the average P/B ratio of similar
companies in its industry or market sector.

2) The price-to-earnings (P/E) ratio should be less than 40% of the stock’s highest P/E over the
previous five years.

3) Look for a share price that is less than 67% (two-thirds) of the tangible per share book value,
AND less than 67% of the company’s net current asset value (NCAV).

Note: The share-price-to-NCAV criterion is sometimes used as a standalone tool for identifying
undervalued stocks. Graham considered a company’s NCAV to be one of the most accurate
representations of a company’s true intrinsic value.

4) A company’s total book value should be greater than its total debt.

Note: A related, or perhaps an alternative, financial metric to this is examining the basic debt
ratio – the current ratio – which should at least be greater than 1.0 and hopefully higher than 2.0.

5) A company’s total debt should not exceed twice the NCAV, and total current liabilities and
long-term debt should not be greater than the firm’s total stockholder equity.

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Investors can experiment with using Graham’s various criteria and determine for themselves
which of the valuation metrics or guidelines they consider to be essential and reliable. There are
some investors who still use only an examination of a stock’s P/B ratio to determine whether or
not a stock is undervalued. Others rely heavily, if not exclusively, on comparing current share
price to the company’s NCAV. More cautious, conservative investors may only buy stocks that
pass every one of Graham’s suggested screening tests.

Alternative Methods of Determining Value

Value investors continue to give Graham and his value investing metrics attention. However, the
development of new angles from which to calculate and assess value means that alternative
methods for identifying underpriced stocks have arisen as well.

One increasing popular value metric is the Discounted Cash Flow (DCF) formula.

DCF and Reverse DCF Valuation

Many accountants and other financial professionals have become ardent fans of DCF analysis.
DCF is one of the few financial metrics that take into account the time value of money – the
notion that money available now is more valuable than the same amount of money available at
some point in the future because whatever money is available now can be invested and thereby
used to generate more money.

DCF analysis uses future free cash flow (FCF) projections and discount rates that are calculated
using the Weighted Average Cost of Capital (WACC) to estimate the present value of a
company, with the underlying idea being that its intrinsic value is largely dependent on the
company’s ability to generate cash flow.

The essential calculation of a DCF analysis is as follows:

Fair Value = The company’s enterprise value – the company’s debt

(Enterprise value is an alternative metric to market capitalization value. It represents market

capitalization + debt + preferred shares – total cash, including cash equivalents).

If the DCF analysis of a company renders a per share value higher than the current share price,
then the stock is considered undervalued.

DCF analysis is particularly well-suited for evaluating companies that have stable, relatively
predictable cash flows since the primary weakness of DCF analysis is that it depends on accurate
estimates of future cash flows.

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Some analysts prefer to use reverse DCF analysis in order to overcome the uncertainty of future
cash flow projections. Reverse DCF analysis starts with a known quantity – the current share
price – and then calculates the cash flows that would be required to generate that current
valuation. Once the required cash flow is determined, then evaluating the company’s stock as
undervalued or overvalued is as simple as making a judgment about how reasonable (or
unreasonable) it is to expect the company to be able to generate the required amount of cash
flows necessary to sustain or advance the current share price.

An undervalued stock is identified when an analyst determines that a company can easily
generate and sustain more than enough cash flow to justify the current share price.

A New Price-Earnings Ratio

Katsenelson’s Absolute P/E Model

Katsenelson’s model, developed by Vitally Katsenelson, is another alternative value investing

analysis tool that is considered particularly ideal for evaluating companies that have strongly
positive, well-established earnings scores. The Katsenelson model focuses on providing investors
a more reliable P/E ratio, known as “absolute P/E.”

The model adjusts the traditional P/E ratio in accord with several variables, such as earnings
growth, dividend yield, and earnings predictability. The formula is as follows:

Absolute PE = (Earnings Growth Points + Dividend Points) x [1 + (1 – Business Risk)] x [1

+ (1 – Financial Risk)] x [1 + (1 – Earnings Visibility)]

Earnings growth points are determined by starting with a no-growth P/E value of 8, and then
adding .65 points for every 100 basis points the projected growth rate increases until you reach
16%. Above 16%, .5 points are added for every 100 basis points in projected growth.

The absolute P/E number produced is then compared to the traditional P/E number. If the
absolute P/E number is higher than the standard P/E ratio, then that indicates the stock is
undervalued. Obviously, the larger the discrepancy between the absolute P/E and the standard
P/E, the better a bargain the stock is. For example, if a stock’s absolute P/E is 20 while the
standard P/E ratio is only 11, then the true intrinsic value of the stock is likely much higher than
the current share price, as the absolute P/E number indicates that investors are probably willing
to pay a lot more for the company’s current earnings.

The Ben Graham Number

The formula for calculating the Ben Graham Number is as follows:

Page | 36
 Ben Graham Number = the square root of [22.5 x (Earnings per share (EPS)) x (Book value
per share)]

For example, the Ben Graham Number for a stock with an EPS of $1.50 and a book value of $10
per share calculates out to $18.37.

Graham generally felt that a company’s P/E ratio shouldn’t be higher than 15 and that its price-
to-book (P/B) ratio shouldn’t exceed 1.5. That’s where the 22.5 in the formula is derived from
(15 x 1.5 = 22.5). However, with the valuation levels that are commonplace these days, the
maximum allowable P/E might be shifted to around 25.

Once you’ve calculated a stock’s Ben Graham Number – which is designed to represent the
actual per-share intrinsic value of the company – you then compare it to the stock’s current share
price.

• If the current share price is lower than the Ben Graham Number, this indicates the stock is
undervalued and may be considered as a buy.
• If the current share price is higher than the Ben Graham Number, then the stock appears
overvalued and not a promising buy candidate.
Where does the Graham Number Come From?

The Graham Number formula was never actually provided by Benjamin Graham. Rather, it
seems to be engineered out of one of Graham’s recommended requirements for the Defensive
Investor. In Chapter 14 of The Intelligent Investor, Graham provided a list of suggested criteria
to help the Defensive Investor find quality securities for consideration. Those criteria are as
follows:

1. Adequate Size of the Enterprise

2. A Sufficiently Strong Financial Condition
3. Earnings Stability
4. Dividend Record
5. Earnings Growth
6. Moderate Price / Earnings Ratio
7. Moderate Ratio of Price to Assets
In the seventh criteria, Moderate Ratio of Price to Assets, Graham says that “Current prices
should not be more than 1.5 times the book value last reported. However, a multiplier of

Page | 37
 earnings below 15 could justify a correspondingly higher multiple of assets. As a rule of thumb,
we suggest that the product of the multiplier times the ratio of price to book value should not
exceed 22.5.” Somewhere along the line, analysts took this suggestion from Graham and
extrapolated it into the Graham Number.

1. Value Investing: How Stocks Become Undervalued

Market Momentum and Herd Mentality

People invest irrationally based on psychological biases rather than market fundamentals. When
a specific stock’s price is rising or when the overall market is rising, they buy. They see that if
they had invested 12 weeks ago, they could have earned 15% by now, and they don’t want to
miss out on potential future gains of the same magnitude. They hear other people bragging about
their paper profits and they want in.

When a specific stock’s price is declining or when the overall market is declining, loss aversion
compels people to sell their stocks. They don’t want to lose everything, and they fear uncertainty.
So instead of keeping their losses on paper and waiting for the market to change directions, they
accept a certain loss by selling. Such investor behavior is so widespread that it affects the prices
of individual stocks, exacerbating downward market movements. Such behavior also has a
dramatic, negative effect on the portfolio returns of people who invest this way.

Bubbles and Market Crashes

When market momentum and the herd mentality run to extremes, bubbles and crashes result. The
early 2000s tech bubble and the mid-2000s housing bubble were fueled by overinvestment that
bid up the prices of tech stocks and real estate beyond what the underlying companies and
properties were worth. When the unsustainable highs began to fall, investors panicked and a
crash ensued, causing some stocks to be priced closer to their true values and others to fall below
their true values. Bubbles are deceptive and unpredictable, but by studying their history we can
prepare to our best ability.

Unnoticed Stocks
Stocks might sell for less than they’re worth because they’re under the radar. Small cap stocks,
foreign stocks, and any other stocks that aren’t in the headlines or aren’t household names
sometimes offer great potential but don’t get the attention they deserve.
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Bad News
Even good companies face setbacks such as litigation and recalls. However, just because a
company experiences one negative event doesn’t mean that the company isn’t still fundamentally
valuable or that its stock won’t bounce back. Companies with real value can experience a
significant drop in share price when something bad happens. Investors often overreact to the
magnitude of the information, opening up buying opportunities for value investors who strictly
follow fundamental principles. Those who are willing to consider the company’s long-term value
and ability to recover can turn these setbacks into profit opportunities.

Underperforming Divisions
Sometimes a company has an unprofitable division that drags down its performance. If the
company sells or closes that division, the company’s financials can improve dramatically. Value
investors who see this potential can buy the stock while its price is depressed and enjoy gains
later.

Failure to Meet Analysts’ Expectations

Analysts do not have a great track record for predicting the future, and yet investors often panic
and sell when a company announces earnings that are lower than analysts’ expectations. This
irrational behavior can temporarily depress a stock’s price.

Cyclicality
It’s common for companies to go through periods of higher and lower profits. The time of year
and the overall economy affect consumers’ moods and cause them to buy more or less. Their
behavior might affect the stock’s price, but it has nothing to do with the company’s long term
underlying value.

For these and other reasons, stock prices can become depressed even as the company continues
to create value for its shareholders. Such situations present profit opportunities for value
investors.

Value Investing: Finding Undervalued Stocks

There are two basic steps to finding undervalued stocks: developing a rough list of stocks you
want to investigate further because they meet your basic screening criteria, then doing a more in-
depth analysis of these stocks by examining the financial data of the selected companies.

Basic Screening Criteria

You can search for a company’s financials through online databases or find quarterly reports and
press releases on the company’s official website.

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Major financial websites (including Investopedia) allow investors to get information such as
stock price, shares outstanding, earnings per share and current news regarding the company and
its industry. You can also see who the stock’s largest owners are, which insiders have placed
trades recently and how many shares they traded. Some websites will also filter stocks according
to criteria you set, such as stocks with a certain P/E ratio. These filters can help you come up
with a broad list of stocks that you want to research further.

Hawaiian Airlines (Nasdaq: HA), November 6, 2017

In-Depth Analysis
Benjamin Graham’s rule states that an undervalued stock is priced at least a third below its
intrinsic value.
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Basic Value Investing Ratios

P/E Ratio
The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current
share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as
the price multiple or the earnings multiple.

The P/E ratio can be calculated as: Market Value per Share / Earnings per Share

Earnings Yield
Earnings yield is the inverse of the earnings multiple. A stock with an earnings multiple of 5 has
an earnings yield of 1/5, or 0.2, more commonly stated as 20%. Since value investors like stocks
with a low earnings multiple (like 5) and earnings yield is the inverse of that number (1/5), we
want to see a high earnings yield (1/5 is better than 1/25). Ordinarily, a high earnings yield tells
investors that a stock generates high earnings relative to its share price.

Insider Purchasing Activity

For our purposes, insiders are the company’s senior managers and directors, plus any
shareholders who own at least 10% of the company’s stock. A company’s managers and
directors have unique knowledge about the companies they run, so if they are purchasing its
stock, it’s reasonable to assume that the company’s prospects look favorable.

Likewise, investors who own at least 10% of a company’s stock wouldn’t have bought so much
if they didn’t see profit potential. If they’re buying even more, they must be seeing greater profit
potential.

On the other hand, a sale of stock by an insider doesn’t necessarily point to bad news about the
company’s anticipated performance, the insider might simply need cash for any number of
personal reasons. Nonetheless, if mass sell-offs are occurring by insiders, such a situation may
warrant further in-depth analysis of the reason behind the sale.

In the case of the 2017 Equifax security breach, for example, the company’s CEO, its president
of US information solutions and its president of workforce solutions sold their stock in early
August, just after Equifax said it discovered the breach but before the company informed the
public. The shares’ value plummeted after the breach was disclosed. A value investor observing
the sales would have wanted to search for a reason behind them before buying or selling any
shares.

The Art of Value Investing

The key to buying an undervalued stock is to thoroughly research the company and not just buy a
stock because a few of its ratios look good or because its price has recently dropped

To increase your odds of accurately answering the questions above, it’s wise to buy companies
that you understand. Warren Buffett takes this approach. Companies that you understand will
most likely be in industries you have worked in or that sell consumer goods that you are familiar
with.

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Well-known investor Peter Lynch strong advocated such a strategy, whereby retail investors can
outperform institutions simply by investing in what they know before Wall Street catches on.

Another strategy that value investors favor is to buy companies whose products or services have
been in demand for a long time and are likely to continue to be in demand. We can find out how
long a company has been in business and research how it has adapted to change over time. It
would be worthwhile to analyze the company’s management and the effectiveness of its
corporate governance to determine how the firm reacts to changing business environments. A
firm with a track record of evolving in the face of change will be a good bet.

Value Investing: Finding Value In Financial Reports And Balance Sheets

Financial Reports
Financial reports present a company’s annual and quarterly performance results. The annual
report is SEC form 10-K and the quarterly report is SEC form 10-Q. Companies are required to
file these reports with the Securities and Exchange Commission (SEC). You can find them at the
SEC website or at the company’s corporate or investor relations website.

You can learn a lot from a company’s annual report. It will explain what products and/or services
the company sells and give you an idea of how the company sees itself. For example, many
people first think of merchandise and Prime shipping when they think of Amazon.com.

However, Amazon’s 2016 annual report says, “We seek to be Earth’s most customer-centric
company. We are guided by four principles: customer obsession rather than competitor focus,
passion for invention, commitment to operational excellence, and long-term thinking. In each of
our segments, we serve our primary customer sets, consisting of consumers, sellers, developers,
enterprises, and content creators. In addition, we provide services, such as advertising services
and co-branded credit card agreements.”

This statement tells investors that the company has a much broader focus than the products and
services it sells. A company’s financial reports will also describe its recent accomplishments,
leadership changes, risk factors, intellectual property, any regulatory changes that affect the
company and more.

Financial reports also provide the financial data that investors want to analyze, such as
revenue, operating expenses, net income, total assets, total debt and more. Financial reports also
make it easy to compare these numbers across time by providing historical data along with
current data. For example, a look at Amazon’s 2016 statement of operations shows that
Amazon’s net sales have increased every year for the last five years, from $61,093 million in
2012 to $135,987 million in 2016. Analyzing historical will help you evaluate growth prospects
and create forecasts.

Select Consolidated Financial Data from Amazon’s 2016 Annual Report

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Source: Amazon 2016 Annual Report, p. 17.

Financial reports can also tell you a lot about the company’s weaknesses. Amazon’s 2016 annual
report says, for example, “Our International Operations Expose Us to a Number of Risks,” “If
We Do Not Successfully Optimize and Operate Our Fulfillment Network and Data Centers, Our
Business Could Be Harmed” and “The Seasonality of Our Business Places Increased Strain on
Our Operations.”As a potential investor, you will want to think about how much of a threat these
risks are to your likelihood of earning a profit.

An essential component of any financial report is the company’s financial statements. We’ll
examine two, the balance sheet and the income statement, that contain many of the numbers
you’ll need for your value investment analysis.

The Balance Sheet

A company’s balance sheet provides a big picture of the company’s financial condition.
The balance sheet consists of two sections, one listing the company’s assets and another listing
its liabilities and equity.

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The assets section is broken down into a company’s cash and cash equivalents; investments;
trade receivables or accounts receivable; inventories; deferred tax assets; intangible
assets; goodwill; property, plant and equipment; and other assets. These subcategories won’t be
identical for every company you examine because different companies have different types of
assets.

The liabilities section lists the company’s accounts payable, accrued liabilities, convertible notes,
long-term debt, other noncurrent liabilities, and any other outstanding debts that the company
may have. The shareholders’ equity section reflects how much money is invested into the
company in addition to cumulative retained earnings. Again, these subcategories won’t be
identical for every company you examine because different companies have different types of
liabilities. For example, an insurance company might list “unearned premiums” as a liability, but
a food service company would not.

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Consolidated Balance Sheets from Amazon’s 2016 Annual Report

Source: Amazon 2016 Annual Report, p. 39.

One important ratio that value investors like to calculate using balance sheet data is called
the current ratio. The current ratio compares the company’s total current assets to its total current
liabilities. Current assets will be utilized within a year and current liabilities must be covered
within the same time frame.

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The higher the ratio, the better, but value investors like to see a current ratio of at least 2 to 1,
meaning that the company has at least twice as many current assets as current liabilities. The
current ratio indicates how easily a company can cover its current obligations and reveals the
firm’s general liquidity position. Comparing a company’s current ratio for the most recent year
to that of previous years and to that of similar companies for the same years will help you put
this number into perspective.

You can also calculate net current assets per share. To get net current assets (also called working
capital or current capital), you subtract current liabilities from current assets. Divide the result by
the number of shares outstanding and you get net current assets per share. (You can find a
company’s shares outstanding via the company’s income statement.) Give greater consideration
to companies where the stock price is no more than 67% of its net current asset value per share.

The balance sheet also provides a snapshot of a company’s long-term finances. Long-term assets
may be lumped together under a term like “fixed assets” or “property, plant and equipment.”
Included in these categories are assets such as the real estate and factories the company owns.
“Intangible assets” is also a long-term asset; it attempts to measure the value of the company’s
intellectual property holdings (copyrights, trademarks and patents). Long-term liabilities are a
company’s financial obligations whose maturity is longer than one year, including real estate
leases and bond issues.

Another important number to get from the balance sheet is the company’s debt-to-assets ratio. To
get this number, divide total liabilities by total assets. Benjamin Graham avoided companies
whose debt exceeded 50% of assets. The lower the company’s debt ratio, the better it is.

The book value per share and price to book ratio are also meaningful. Book value is the
company’s net worth: its assets minus its liabilities. Calculate book value per share by dividing
the company’s net worth by the number of shares outstanding. Value investors are interested in
companies whose stock price is below book value per share. If a company has a net worth of $10
million and it has 500,000 shares outstanding, its book value per share is $10,000,000 / 500,000,
or $20. If the stock is trading for $15, it may be worth researching further. Comparing the $15
stock price to the $20 book value gives us the price-to-book ratio of $15/$20 = 0.75.

Value Investing: Finding Value in Income Statements

A company’s income statement tells you how much money it has taken in and how much it has
paid out over a year or a quarter. Looking at the annual income statement rather than a quarterly
statement will give you a better idea of the company’s overall position since many companies
experience fluctuations in sales volume during the year.

Revenue
The first item on the income statement tells you how much money the company received from
selling its products and/or services to its customers. This figure may be labeled “revenues,” “net
sales,” “net operating revenues” or something similar. By comparing the current year’s figure to
previous years’ figures, you can see if the company’s sales are improving over time. Increasing
sales also indicate that the company is growing. Amazon reported total net sales of $135,987
million in 2016, for example, and this represented a significant increase over the $107,006
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million it reported in 2015 and the $88,988 million it reported in 2014. Though Amazon is often
considered a growth stock, not a value stock, we’re using it as an example here because everyone
is familiar with the company and its financial statements are easy to read.

Consolidated Statements of Operations from Amazon’s 2016 Annual Report

Source: Amazon 2016 Annual Report, p. 37.

Expenses
Next, the income statement gets into the company’s expenses. This second line might be called
“cost of products sold,” “cost of goods sold,” “cost of sales” (in Amazon’s case), “cost of
services” or some variation thereof. Subtracting cost of revenue from actual revenue generated

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produces gross profit. Amazon reported cost of sales at $88,265 million for 2016. Subtracting
this figure from total net sales of $135,987 yields a gross profit of $47,722 million.

There are more expenses to account for, however, and gross profits must be high enough to cover
those expenses and leave a net profit. Companies have selling, general and administrative
expenses(SG&A). Sometimes companies call these “selling, marketing and administrative
expenses,” or they might break the category down and list marketing expenses separately from
general and administrative expenses. Some companies, like biotech companies, have research
and development expenses in addition to SG&A. Amortization and depreciation are also
considered operating expenses.

Income
Subtracting total operating expenses from total net sales gives you the company’s operating
income. Amazon’s total operating expenses for 2016 were $131,801 million and included
fulfillment, marketing, technology and content, general and administrative, and other.
Subtracting $131,801 million in operating expenses from $135,987 million in total net sales left
Amazon with $4,186 million in operating income.

After subtracting interest expenses and income taxes from operating income — in addition to
making any other company-specific adjustments — you get the company’s net income, also
called net earnings or net loss. This number is the bottom line. For 2016, Amazon’s net income
or bottom line was $2,371 million.

Earnings per Share

The last lines of the income statement present the company’s basic earnings per share and diluted
earnings per share. Basic EPS divides net income by number of shares outstanding. Some
companies describe shares outstanding as “basic average shares outstanding” or “shares used in
calculation of earnings per share.” Amazon’s basic weighted average shares outstanding for 2016
amounted to 474 million. If we divide $2,371 million of net earnings by 474 million shares
outstanding, we get basic earnings per share of $5.01. Analysts and investors are always looking
for earnings per share growth.

The income statement also presents figures for diluted earnings per share. Most companies issue
convertible securities such as stock options, convertible bonds, preferred stock and warrants.
Diluted EPS represents earnings per share if all these financial instruments were converted to
shares. If convertibles are turned into shares, there will be more total shares outstanding, and
each stockholder will own a smaller percentage of the company. Owning a smaller percentage of
the company means owning a smaller percentage of the profits. Diluted EPS will thus be lower
than basic EPS, but value investors want this difference to be small.

The income statement also shows how the number of shares outstanding has changed over time.
Amazon’s 2016 10-K, for example, shows that its basic shares were 462 million in 2014, 477
million in 2015, and 484 million in 2016. Although growth companies like Amazon will
typically increase the number of outstanding shares annually, value stocks will have a decreasing
number of shares. That decreasing number reflects the existence of share buyback programs,
which indicate management’s confidence in the company’s future performance. It also means
that each share of the company’s stock is entitled to a higher percentage of earnings. On the other
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hand, if shares outstanding are increasing, it means that the company is handing out lots of stock
options, which will dilute investors’ earnings, or that the company is raising more money
through new stock offerings.

Calculating Profitability
Profit margin can be a more helpful indicator of a company’s performance than net sales or net
revenue because it takes costs into account. There are two types of profit margin: net and gross.
Calculated as a percentage, net profit margin divides net profit by sales, while gross profit
margin divides gross profit by sales. Remember, the numbers you need for these calculations are
located at bottom and top of the income statement. For 2016, Amazon’s gross profit margin was
47,722 / 135,987 = 35.09%; its net profit margin was 2,371 / 135,987 = 1.7%.

A low profit margin indicates that a company’s costs are too high or that the market won’t
support a high enough price for its products and services. However, there is not an absolute
number that is considered a good profit margin; what’s considered good depends on the
company’s industry. Comparing a company’s profit margins to those of its competitors can
indicate whether the company has a good profit margin and how the company may perform long
term. Comparing a company’s most recent year’s profit margin to its previous year’s profit
margins tells you how the company is performing over time. Value investors want to see a
company’s profit margin be higher than that of its competitors, and they want the companies they
invest in to have consistent or increasing profit margins over time.

Value investors are long-term investors, so it’s important that when you look at a company’s
income statement, you see long-term profitability.

Value investors find it especially helpful to compare stocks they’re considering to those of
similar companies that have recently been acquired. The price a stock sells for in an acquisition
often accurately reflects the company’s true value since acquisitions are transacted by well-
informed investors.

Value Investing: Managing The Risks In Value Investing

This section describes the key risks to be aware of and offers guidance on how to mitigate them.

Basing Your Calculations on the Wrong Numbers

Since value investing decisions are partly based on an analysis of financial statements, it is
imperative that you perform these calculations correctly. Using the wrong numbers, performing
the wrong calculation or making a mathematical typo can result in basing an investment decision
on faulty information.

Overlooking Extraordinary Gains or Losses

Some years, companies experience unusually large losses or gains from events such as natural
disasters, corporate restructuring or unusual lawsuits and will report these on the income
statement under a label such as “extraordinary item — gain” or “extraordinary item — loss.”
When making your calculations, it is important to remove these financial anomalies from the

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 equation to get a better idea of how the company might perform in an ordinary year.
Extraordinary items are supposed to be unusual and nonrecurring.

Ignoring the Flaws in Ratio Analysis

The problem with financial ratios is that they can be calculated in different ways. Here are a few
factors that can affect the meaning of these ratios:

• They can be calculated with before-tax or after-tax numbers.

• Some ratios provide only rough estimates.
• A company’s reported earnings per share (EPS) can vary significantly depending on how
“earnings” is defined.
• Companies differ in their accounting methodologies, making it difficult to accurately compare
different companies on the same ratios.

Overpaying
One of the biggest risks in value investing lies in overpaying for a stock. When you underpay for
a stock, you reduce the amount of money you could lose if the stock performs poorly. The closer
you pay to the stock’s fair market value the bigger your risk of not earning money or even losing
capital. One of the fundamental principles of value investing is to build a margin of safety into
all your investments. This means purchasing stocks at a price of around two-thirds or less of
their intrinsic value. Value investors want to risk as little capital as possible in potentially
overvalued assets, so they try not to overpay for investments.

Not Diversifying
Conventional investment wisdom says that investing in individual stocks can be a high-risk
strategy. We are taught to invest in multiple stocks or stock indexes so that we have exposure to
a wide variety of companies and economic sectors. However, some value investors believe that
you can have a diversified portfolio even if you only own a small number of stocks, as long as
you choose stocks that represent different industries and different sectors of the economy. Value
investor and investment manager Christopher H. Browne recommends owning a minimum of 10
stocks in his “Little Book of Value Investing.” Famous value investor Benjamin
Graham suggested that 10 to 30 companies is enough to adequately diversify.

On the other hand, the authors of “Value Investing for Dummies,” 2nd. ed., say that the more
stocks you own, the greater your chances are of achieving average market returns. They
recommend investing in only a few companies and watching them closely.

Value investing is a long-term strategy. Warren Buffett, for example, buys stocks with the
intention of holding them almost indefinitely. He once said, “I never attempt to make money on
the stock market. I buy on the assumption that they could close the market the next day and not
reopen it for five years.” By holding a variety of stocks and maintaining a long-term outlook, you
can sell your stocks only when their price exceeds their fair market value.

Basing Your Investment Decisions on Fraudulent Accounting Statements

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One strategy is to read the footnotes. These are the notes that explain a company’s financial
statements in greater detail. The notes follow the statements and explain the company’s
accounting methods and elaborate on reported results. If the footnotes are unintelligible or the
information they present seems unreasonable, you’ll have a better idea of whether to pass on the
stock.

Sample Footnotes from Amazon’s 2016 Annual Report

Source: Amazon 2016 Annual Report, p. 68.

Not Comparing Competitors’ Performance

Comparing a company’s stock to that of its competitors is one way value investors analyze their
potential investments. Companies differ in their accounting policies in ways that are perfectly
legal. When you’re comparing one company’s P/E ratio to another’s, you have to make sure that
EPS has been calculated the same way for both companies. If companies use different
accounting principles, you will need to adjust the numbers accordingly.

Selling at the Wrong Time

Even if you do everything right in researching and purchasing your stocks, your entire strategy
can fall apart if you sell at the wrong time. The wrong time to sell is when the market is suffering
and stock prices are falling simply because investors are panicking, not because they are

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 assessing the quality of the underlying companies they have invested in. Another bad time to sell
is when a stock’s price drops just because its earnings have fallen short of analysts’ expectations.

The ideal time to sell your stock is when shares are overpriced relative to the company’s intrinsic
value

Growth vs. value: two approaches to stock investing

Growth and value are two fundamental approaches, or styles, in stock and stock mutual fund
investing. Growth investors seek companies that offer strong earnings growth while value
investors seek stocks that appear to be undervalued by the marketplace. Because the two styles
complement each other, they can help add diversity to your portfolio when used together.

Growth and value defined

Growth stocks represent companies that have demonstrated better-than-average gains in earnings
in recent years and that are expected to continue delivering high levels of profit growth.
"Emerging" growth companies are those that have the potential to achieve high earnings growth,
but have not established a history of strong earnings growth.

The key characteristics of growth funds are as follows:

▪ Higher priced than broader market. Investors are willing to pay high price-to-earnings
multiples with the expectation of selling them at even higher prices as the companies continue to
grow
▪ High earnings growth records. While the earnings of some companies may be depressed
during periods of slower economic improvement, growth companies may potentially continue to
achieve high earnings growth regardless of economic conditions
▪ More volatile than broader market. The risk in buying a given growth stock is that its lofty
price could fall sharply on any negative news about the company, particularly if earnings
disappoint.
Value fund managers look for companies that have fallen out of favor but still have good
fundamentals. The value group may also include stocks on new companies that have yet to be
recognized by investors.

The key characteristics of value funds include:

▪ Lower priced than the broader market. The idea behind value investing is that stocks of good
companies will bounce back in time if and when the true value is recognized by other investors
▪ Priced below similar companies in industry. Many value investors believe that a majority of
value stocks may be more suited to longer-term investors and may carry more risk of price
fluctuation than growth stocks
▪ Carry somewhat less risk than broader market. However, as they take time to turn around,
value stocks may be more suited to longer-term investors and may carry more risk of price
fluctuation than growth stock.

History shows us that:

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▪ Growth stocks, in general, have the potential to perform better when interest rates are falling and
company earnings are rising. However, they may also be the first to be punished when the
economy is cooling.

▪ Value stocks, often stocks of cyclical industries, may do well early in an economic recovery but
are typically more likely to lag in a sustained bull market
Growth vs. value: compare the performance

Both growth and value stocks have taken turns leading and lagging one another during different
markets and economic conditions.

Source: ChartSource®, DST Systems, Inc. Based on calendar-year returns from 1992 to 2016.
Growth stocks are represented by a composite of the S&P 500/BARRA Growth index and the
S&P 500/Citi Growth index. Value stocks are represented by a composite of the S&P
500/BARRA Value index and the S&P 500/Citi Value index. Past performance is not a
guarantee of future results. Index performance does not reflect the effects of investing costs and
taxes. Actual results would vary from benchmarks and would likely have been lower. It is not
possible to invest directly in an index. © 2017, DST Systems, Inc. Reproduction in whole or in
part prohibited, except by permission. All rights reserved. Not responsible for any errors or
omissions. (CS000170)

The 5 Major Stock Investing Strategies for Value Investors

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 The 5 Strategies

Benjamin Graham identified five categories of common stock investing that could conceivably
result in satisfactory or more than satisfactory returns. For an engaged portfolio manager who
wanted to compound capital, he spelled these out in his 1949 edition of The Intelligent Investor:

• General Trading - Anticipating or participating in the moves of the market as a whole, as

reflected in the familiar "averages"
• Selective Trading - Picking out issues which, over a period of a year or less, will do better in the
market than the average stock
• Buying Cheap and Selling Dear - Coming into the market when prices and sentiment are
depressed and selling out when both are exalted
• Long-Pull Selection - Picking out companies which will prosper over the years far more than
the average enterprise. (These are often referred to as "growth stocks.")
• Bargain Purchases - Selecting issues which are selling considerably below their true value, as
measured by reasonably dependable techniques

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3.2 DATA ANALYSIS

How to Value a Stock with the Benjamin Graham Formula

Using Benjamin Graham’s Formula to Value a Stock

Intrinsic Value

“The newer approach to security analysis attempts to value a common stock independently of its
market price. If the value found is substantially above or below the current price, the analyst
concludes that the issue should be bought or disposed of. This independent value has a variety of
names, the most familiar of which is “intrinsic value”.

– Ben Graham, Security Analysis (1951 Edition)

There are many different formulas that can be used to determine the intrinsic value.

Definition of Intrinsic Value

“A general definition of intrinsic value would be that value which is justified by the facts—e.g.
assets, earnings, dividends, definite prospects. In the usual case, the most important single factor
determining value is now held to be the indicated average future earning power. The intrinsic
value would then be found by first estimating this earning power, and then multiplying that
estimate by an appropriate ‘capitalization factor’”.

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Ben Graham, Security Analysis

By Joel Greenblat,

“Value investing is figuring out what something is worth and paying a lot less for it.”

From Investopedia.

“The intrinsic value is the actual value of a company or an asset based on an underlying
perception of its true value including all aspects of the business, in terms of both tangible and
intangible factors. This value may or may not be the same as the current market value.
Additionally, intrinsic value is primarily used in options pricing to indicate the amount an option
is in the money.”

Intrinsic value is used for many things. It is mostly associated with buying stocks but it can be
used for just about anything. Value investors use this theory and formulas to determine what the
value of a company is. They use it to help find out what price they need to pay to achieve a
margin of safety.

Intrinsic value focuses on what a company is worth, not how much it is trading for on the stock
market. Price does not equal value.

“Price is what you pay, value is what you get.”

Warren Buffett

Price is a function of the vagaries of the stock market.

Value is something much more valuable than the price you pay for something.

In the stock market world finding the intrinsic value is of utmost importance. This gives us the
ability to determine a margin of safety. Which is critical to determining whether or not this is a
company we want to invest in.

Why does intrinsic value matter?

In a broad sense using an intrinsic value formula to calculate that value gives you the opportunity
to decide whether or not to buy or sell a company.

Analysts use these formulas to determine whether to assign “undervalued” or “overvalued” tag to
their analysis of a company.

There are so many other factors that go into deciding whether the company is over or
undervalued. The analysts use these formulas because it is an easy way to determine a value and
then compare it to the price that is being quoted on the market.

Using the intrinsic value formula should be a means for you to determine the value of a company
and then determine your margin of safety.
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 This is what Buffett had to say about the subject.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the
relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is
the discounted value of the cash that can be taken out of a business during its remaining life.”

“The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic
value is an estimate rather than a precise figure… two people looking at the same set of facts…
will almost inevitably come up with at least slightly different intrinsic value figures.”

Some of the key concepts to keep in mind that we are trying to determine are:

• Looking at a company’s historical financials

• Profitability
• Stability of the operating business
• Balance sheet
• Evaluating its competitiveness or moat
• Understanding its future prospects
• Evaluating management
We get more value out of a great business in the long run than simply paying a cheap price.

What do we get when we buy a company?

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In simple terms, we are buying future earnings. If you notice to above quote by Graham he
mentions earnings as the “most important single factor determining value”.

When we buy a business we are assigning a value to that business’ future earnings.

What are earnings? According to thebalance.com

“The earnings of a business are the same as its net income or its profit. Either term means the
same thing.

Earnings are usually calculated as all revenues (sales) minus the cost of sales, operating
expenses, and taxes, over a given period of time (usually a quarter or a year).

For example, let’s say the gross sales of a company are $500,000 for a year. Reduce this number
by the cost of sales at $300,000, operating expenses (including depreciation) of $80,000, and
taxes of $20,000. The result is the company’s earnings (profit, net income) of $100,000.”

When it comes to earnings, in regards to intrinsic value. We are looking for future earnings. Not
really focusing on what has happened in the past. But looking for a prediction of the company’s
future earnings.

We are looking for future earnings or the earning power of the company. We want to see a
constant stream of cash from the company over the coming years. The intrinsic value formula
will help you determine how much the company is worth and then we can decide how much
those future earnings are worth to us.

Intrinsic Value Formula per Ben Graham

In Graham's words: "Our study of the various methods has led us to suggest a foreshortened and
quite simple formula for the evaluation of growth stocks, which is intended to produce figures
fairly close to those resulting from the more refined mathematical calculations."

His original formula is:

V = EPS X (8.5 + 2g)

Where:

V = Intrinsic Value

EPS = The trailing twelve month EPS (Earnings Per Share)

8.5 = Is the PE ratio of a stock that has 0% growth

G = growth rate for the next 7 to 10 years

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The formula was later revised to

The formula is basically the same with two exceptions. He added a required rate of return, which
he set at 4.4. All this would be divided by AAA corporate rate bond, which would be his risk-
free rate. This would be represented by his Y.

Adjust Earnings Per Share in the Graham Formula

Intrinsic value shouldn’t be calculated based on a single 12 month period which is why we have
the EPS automatically adjusted to a normalized number ignoring one time huge or depressed
earnings based on 5 year or 10 year history depending on the company you are looking at.

EPS is never really a good number on its own as it is highly prone to manipulation with modern
accounting methods. Another reason why you have to always normalize EPS is because
management will never understate earnings on purpose. While companies may follow accounting
procedures which inflates earnings, they will never go out of their way to make it lower than it is.

Another variation of the formula will use the projected EPS but unless it is a pure growth stock
with exponential growth like characteristics, the stock value will become absurdly high.

Adjust Growth Rate Per Today’s Environment

The drawback of the Benjamin Graham formula is that growth is a big element of the overall
valuation.

For the actual growth rate, if convenience is important, you could just use the analyst 5yr
predictions from Yahoo or other sites, but for most value stocks that Mr. Jae Jun searched for,
predictability is important so a regression of the historical EPS to project the following year is a
method he likes to use.

The “2 x G” however, is quite aggressive. So he recently reduced the multiplier to 1 instead of 2.

You’ll see why in the examples below.

Corporate Bond Rate

We currently have the set up to use the 20 year A corporate rate which is just above 6%. This
provides a slightly more conservative intrinsic value than the 20 year AAA or AA.

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 If you look at the current settings, it is set up for 3.56%.

To be more conservative I would like to suggest we use a modification to the formula that Jae
Jun at Old School Value came up with. I like his thoughts and he makes some great observations.

Final Adjusted Benjamin Graham Formula

So by making the adjustments, the new formula is now

Bejamin Graham Formula Adjusted Version

Testing the Adjusted Graham Formula

Let’s test this across several different companies and industries.

Alphabet

• EPS = 34.47
• g = 15.8%
• Y = 3.56%

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 Graham Formula Calculator

The resulting Graham formula gives a value of $971.36

An important point to keep in mind is that when Graham provided this equation, it was to
simulate a growth stock based on the concepts of value investing.

Let’s look at Facebook (FB).

• EPS =4.14
• g = 29.4%
• Y = 3.56%

Ben Graham Formula Calculation with OSV Spreadsheet Analyzer for Facebook | Click to
Enlarge

The intrinsic value comes out to $186.29.

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 If I used the original Graham’s Formula, this is what Facebook would look like.

Original Ben Graham Formula Calculation Used

The intrinsic value comes out to $344.44.

My adjusted version of no growth PE of 7 and 1xg compared to the original version of 8.5 and
2xg.

What this shows is that:

1. the original Graham’s formula is aggressive

2. should be considered as the upper range
3. needs to be put into today’s context
There was no Facebook, Microsoft, Google back in Graham’s time.

High growth companies didn’t achieve 30, 40, 100% growth like some do today.

On the other end of the spectrum, here’s the calculation for Caterpillar (CAT).

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 Caterpillar Graham Calculation Example

• EPS is 3.26
• The expected growth rate is 8.6%
• Corp rate is 3.56%
Additionally, based on the current price and if you reverse engineer the Graham’s Formula, it
tells you that the market is expecting a 17.57% from the current price.

The actual forward looking growth is much lower at 8.6%.

Thus the Graham’s formula comes out to $62.86 with a zero margin of safety.

Let’s try adjusted Graham’s formula on some companies during a different time period.

Facebook (FB)

EPS = 3.49

G = growth of 23.50%

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Y = 20 year AAA corporate bond of 3.98

So after plugging all the numbers from above into the formula, we get the number of $117.68.

Walmart (WMT)

EPS = 4.57

Growth = 2.83

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20 AAA Corporate Bond or Y = 3.98

So our intrinsic value for Walmart would be $50.12

we’ll take a look at Gamestop. They are a video game, electronics, and wireless services, retailer.
Their market cap is $2.6 Billion, which is quite a bit smaller than Walmart or Facebook. So I
thought they would be a good choice to see how a smaller company stacks up.

Gamestop (GME)

EPS = 3.78

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Growth = 7.25

20 AAA Corporate Bond or Y = 3.98

So our intrinsic value for Gamestop would be $60.09

Principal Financial Group (PFG)

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 Principal Financial Group is a global financial company that specializes in retirement accounts,
insurance, and investments. Their market cap is $17.8 Billion so smaller than the big boys of the
market.

• EPS = 4.50
• Growth = 7.83
• Y = 3.98
After plugging in our numbers we have an intrinsic value of $73.78.

After calculating intrinsic value

Looking at the formula for calculating intrinsic value, we can take those numbers to begin the
next step which would be to determine the margin of safety that we would want to calculate in.

Let’s take a look at our results from our calculations. We should also compare them to current
market price of each company. We can then see how it fares to the current price and whether or
not we can achieve any margin of safety at this time.

Intrinsic
Ticker Current Price Difference Margin of Safety
Value

FB 133.85 117.68 -16.17 -13.74%

WMT 68.66 50.12 -18.54 -36.99%

GME 25.74 60.09 34.35 57.16%

PFG 62.06 73.78 11.72 15.89%

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We can see by the numbers that both Facebook and Walmart are quite a bit above their intrinsic
value. Both are selling for a price that is above what we feel they are worth.

As for the other two, you can see that they are currently priced below their intrinsic value. In the
case of Gamestop, quite a lot below.

This gives us a snapshot of the values of these companies as well as a comparison to their current
price. In the case of both Facebook and Walmart, they are both overpriced according to our
intrinsic value formula.

This exercise has been done to try to determine what we feel these companies are worth. We do
this to arrive at a price that we would be willing to pay and then we assign a margin of safety to
that number.

Summing Up

Benjamin Graham offered a very simple formula to calculate a growth stock. It can be applied to
other sectors and industries, but you must put it into context by adjusting the original formula.

Always practice margin of safety investing as well as understanding that valuation is finding a
range of numbers. There is no such thing as an absolute range. Consider the Graham
Formula to be the upper end of the valuation range.

Indian Scenario
In order to look at how the two different investment styles have worked in India, we have
analysed the returns of two MSCI (Morgan Stanley Capital International Index) indices - growth
index versus a value index over a long time period.

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Source: MSCI

You can see that from 2005 to 2012, the value index outperformed the growth index in most
years. However, post 2012, growth index has outperformed value index. In the last 5 years,
MSCI Growth Index has given 12.35% annualized returns, while MSCI Value Index has given
only 8.7% annualized returns. The chart below shows the growth of Rs 1 lakh invested in MSCI
Growth Index versus Value Index over the last 5 years (please note that, we have used year end
index values in this chart).

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Source: MSCI

You can see that, MSCI Growth Index outperformed MSCI Value Index over the last 5 years.
The chart below shows the growth of Rs 1 lakh in MSCI Growth Index and MSCI Value Index
over the last 13 years (please note that, we have used year end index values in this chart).

Source: MSCI
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You can see that, the growth of Rs 1 lakh over the last 14 years has been almost the same in
Growth Index and Value Index. However, for most parts of the last 14 year time-frame, value
index outperformed.
Summary
Let us refer back to the annual returns chart of the indices. 2004 to 2008 was a great bull run for
stocks in India. When valuations appeared to be rich, especially in 2006 and 2007, the Value
Index outperformed. When the market crashed in 2008, the growth stocks suffered more than
value stocks. Even when the market recovered in 2009, value stocks outperformed. However,
from 2010 onwards growth stocks outperformed. There is a saying in the stock market that, price
runs ahead of earnings growth. While valuations (price) and earnings go hand in hand, there can
be short term distortions. When valuations become a concern, value stocks tend to perform better
(see the period from 2005 to 2008). On the other hand, when earnings growth is the most
important concern, then growth stocks are rewarded (see the period from 2013 to 2017). In an
investment cycle, we will see both and therefore, there will times when growth stocks will
outperform value stock and vice versa.

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 CHAPTER 4
THE CONCLUSIONS

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 4.1 CONCLUSION
Value investors are always looking to buy undervalued stocks at a discount in order to make
profits with minimal risk. There are a variety of tools and approaches that investors can use to try
to determine the true value of a stock and whether or not it’s a good fit for their investment
portfolio.

The best stock valuation process is never just a mathematical formula that one plugs numbers
into and then in return receives a solid, guaranteed determination of a particular stock as a
“good” or “bad” investment. While there are important stock valuation formulas and financial
metrics to consider, the process of evaluating a stock as a potential addition to your investment
portfolio is ultimately part art and part science – and partly a skill that can only be mastered with
time and practice.

Each investor has to discover their own personal stock investment strategies that best suit their
individual wants or needs, as well as their investment “personality”. You may find that
combining the approaches discussed here is what works best for you. The investing strategy or
strategies you employ will often change during the course of your life as your financial situation
and goals shift. Don’t be afraid to shake things up a bit and diversify the ways in which you
invest, but strive to always maintain a firm grasp on what your investment approach entails and
how it will likely affect your portfolio and your finances.

Value investors get significant discounts on their stock purchases by questioning the wisdom of
market prices. These significant discounts allow them to not only build in a margin of safety that
limits their losses in case their purchases don’t work out, but to earn high returns by holding onto
their investments until they rise to meet or exceed their true value.

Studies show that value investing has outperformed growth over extended periods of time on a
value-adjusted basis. Value investors argue that a short-term focus can often push stock prices to
low levels, which creates great buying opportunities for value investors.

Our findings shows us that:

▪ Growth stocks, in general, have the potential to perform better when interest rates are falling and
company earnings are rising. However, they may also be the first to be punished when the
economy is cooling.

▪ Value stocks, often stocks of cyclical industries, may do well early in an economic recovery but
are typically more likely to lag in a sustained bull market When investing long term, some
individuals combine growth and value stocks or funds for the potential of high returns with less
risk. This approach allows investors to, in theory, gain throughout economic cycles in which the
general market situations favor either the growth or value investment style, smoothing any
returns over time.

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4.2 SUGGESTIONS & RECOMMENDATIONS
A Fusion of Value and Growth

If you’re considering a long-term approach to investing, a fusion of value and growth investing,
as Buffet so effectively employs, may be worth your consideration. There are good reasons to
back up taking these stock investment strategies.

Historically speaking, value stocks are usually the stocks of companies in cyclical industries,
which are largely made up of businesses producing goods and services that people use their
discretionary income on. The airline industry is a good example; people fly more when the
business cycle is on an uptrend and fly less when it swings downward because they have more
and less discretionary income, respectively. Because of this, value stocks typically perform well
in the market during times of economic recovery and prosperity, but they are likely to fall behind
when a bull market is sustained for a long period of time.

Growth stocks typically perform better when interest rates drop and companies’ earnings take
off. They are also typically the stocks that continue to rise even in the late stages of a long-term
bull market. On the other hand, these are usually the first stocks to take a beating when the
economy slows down.

A fusion of growth and value investing offers you the opportunity to enjoy higher returns on
your investment while reducing a substantial amount of your risk. Theoretically, if you employ
both a value investing strategy for buying some stocks while using a growth investing strategy
for buying other stocks, you can generate optimal earnings during virtually any economic cycle,
and any fluctuations in returns will be more likely to balance out in your favor over time.

When investing long term, individuals should combine growth and value stocks or funds for the
potential of high returns with less risk. This approach allows investors to, in theory, gain
throughout economic cycles in which the general market situations favor either the growth or
value investment style, smoothing any returns over time.

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BIBLIOGRAPHY
1. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/a-guide-to-
value-investing/
2. https://www.ft.com/content/d6639266-b406-11e3-a102-00144feabdc0
3. http://investcorrectly.in/financial-planning/what-is-value-investing/
4. https://en.wikipedia.org/wiki/Value_investing
5. http://www.aaii.com/journal/article/three-value-investing-benchmarks.touch
6. https://vintagevalueinvesting.com/the-walter-schloss-approach-to-value-investing/
7. https://www.investopedia.com/university/value-investing/value-investing10.asp
8. https://www.merrilledge.com/article/growth-vs-value-investing-two-approaches-to-stocks
9. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/stock-
investment-strategies/
10. https://www.thebalance.com/value-investing-strategies-stocks-357157
11. https://www.oldschoolvalue.com/blog/valuation-methods/value-stocks-benjamin-graham-
formula/
12. https://en.wikipedia.org/wiki/Benjamin_Graham_formula
13. http://intrinsicvalueformula.com/intrinsic-value-formula-for-beginners/
14. https://cabotwealth.com/daily/value-investing/benjamin-grahams-value-stock-criteria/
15. http://www.moderngraham.com/2015/09/09/how-to-tell-the-difference-between-the-graham-
formula-and-the-graham-number/
16. https://www.joshuakennon.com/benjamin-graham-intrinsic-value-formula/
17. https://www.oldschoolvalue.com/blog/investing-strategy/benjamin-graham-investing-
checklist/
18. http://www.fusioninvesting.com/2009/08/benjamin-graham-checklists-and-formulas/
19. https://www.advisorkhoj.com/smf/value-investing-versus-growth-investing-in-india

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