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How Value Investing Works

January 10, 2012

A value investor is somebody that believes the market is an unreliable means of determining the value of investments. Therefore instead watching the movements of the market he or she tries to determine the real value of equities and securities.

This is usually done through a careful analysis of the underlying value of a vehicle. A value investor will usually read through the prospectus, yearly statements and other documentation available an investment. In the case of a stock he or she will take a close look at the industry and may even visit the facilities of a company he or she is investing in.

Cash Value is the Key

Value investors believe that a decision to purchase a stock should be based upon its present cash value not on any future value. The value investor is not interested in growth potential or future earnings. He or she wants to know what the investment is worth now.

This is why value investors concentrate upon existing companies with a proven track record. A value investor will ignore the hot IPO and purchase an established company such as Microsoft. Microsoft has a track record, a proven product and an existing customer base. It is making money right now so its earnings are real.

Value investors also look at the amount of debt a company has. They would not buy shares in a growing retailer that has issued a lot of paper to finance expansion plans. Instead they would purchase a smaller chain with a large cash reserve.

Value Investing Formulas

A lot of value investors base their decisions upon a formula. The classic formula was invented by the great investor Ben Graham in the 1930s. It is a stock’s intrinsic value is determined by multiplying current earnings x the expected annual growth rate. The expected annual growth rate is the amount by which the value is supposed to grow over a 7 to 10 year period.

As you can see value investors are interested in long term growth not in short term gains. They are also interested in security and a margin of safety which is why they look for proven companies with a track record of making money.

Most value investment formulas also contain a margin of safety. That is an estimated level of risk with the stock. If the margin of safety is too small value investors will not buy. If you want to test value investing formulas there are a number of value investment simulators available online.

Value Investing vs. Speculation

Value investing as practiced by people like Ben Graham and his pupil Warren Buffett is intended as an alternative to speculation. Speculation is the purchase of securities, commodities or equities solely for short term gain.

The speculator is not interested in intrinsic value because she wants to sell for a quick profit. The value investor wants something that she can hold onto for a long time. That is why he or she carefully evaluates everything he or she buys.

Limitations to Value Investing

There are some serious limitations to value investing its practitioners often miss out on a lot of the excitement inherent in the market. They usually miss the huge profits made in bull markets but they also miss the losses from bear markets.

It is a great strategy for retirement investment but not for an active trader. People who like to constantly watch and monitor the market often grow bored with it.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Annuity Definition, Annuity Rate, and Best Annuity Rates.

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