For several years, value investing has been a paradigm of investment methodology. Big-name value investors like Warren Buffett have made the concept very popular. However, fewer people have heard of Buffett’s teacher and friend Benjamin Graham. Graham is often credited with introducing the concept of deep value investing. It originates from Graham’s original work on classical value investing. So what is deep value investing?
Deep value investing is becoming a popular new investment paradigm. So we will take a look at deep value investing. We will also figure out how it works and cover the advantages and benefits of this investment methodology.
Deep Value Investing Definition
Deep value investing can best be described as a quantitative investment methodology that is based on finding undervalued stocks that are priced well below the net current asset value (NCAV).This kind of investing is not so much interested in investing in stocks that will grow the most per se, but stocks whose growth gives you more value per dollar than you put into your investments.
In other words, deep value investing is about finding deep value stocks that have a high intrinsic value relative to their market price. Stocks with a high intrinsic value are more likely to have better future returns. INtrinsic value can be calculated in several ways, but commonly draws on facts such as total assets, earnings, dividends, risks, future cash flow, etc.
How Does Deep Value Investing Work?
Deep value investing is not so much a rigid formula for investing but rather a general investment philosophy that can be helpful in several ways. One of the key aspects of traditional value investing is the focus on quantitative metrics. Value investing is, at least as described by Graham, should be all about quantitative metrics. The point is to find securities that are trading on the market at prices well below their calculated net asset value.
Notably, Graham himself did not care much about more abstract aspects of companies like their management, reputation, or public goodwill. He argued that when it came to value investing, one should try to focus on purely objective metrics. This point of contention is a major difference between Graham’s classical value approach and Buffett’s characteristic approach. Buffet has long preached about the necessity of factoring in things like competitive advantages and management skill, but Graham’s methodology is mostly absent of these kinds of evaluation metrics.
The basic goal behind deep investing is to get the most out of every dollar that you put into your investments. The general logic is that if you are buying stocks at well below their intrinsic value, it’s likely the price will rise and you will make money. The greater the difference between estimated intrinsic value and market value, the more you would be getting out of every dollar you are investing.
Notice that this strategy does not necessarily mean that you want securities with the highest intrinsic value, but those that have a high ratio of intrinsic to market value.
How to Identify Deep Value Stocks
The idea behind finding deep value stocks is finding stocks that have high intrinsic value. Intrinsic value is a notoriously ambiguous term. However, it can basically be understood as the valuation that a knowledgeable business person would place on a company. In that sense, notions of intrinsic value will always be inherently subjective as different people weigh aspects differently,
As a general rule of thumb, intrinsic value can be estimated based on a company’s net asset value. Basically, if you add up all the assets, subtract all debts, and you are left with a big number, then the company has high intrinsic value. Stocks that have an intrinsic value significantly above the market value are good deep value common stock candidates.
Deep Value Investing Strategy
Like we said earlier, every deep value investor will have a different strategy based on how they interpret intrinsic value. But here is a basic skeleton of a strategy.
First, start by identifying the net current asset value of a company. You can calculate NCAV with this formula:
NCAV = Total Assets – Total Liabilities – Preferred Shares
This is a rough schematic and modification can occur based on investment preferences. POnce you come to a suitable calculation, take that number and divide it by the total number of outstanding shares. The number you have will let you know the net asset value per share. The next thing to do is compare the market value per share to the net asset value per share.
This margin means providing a lot of safety as the company can essentially be up for liquidation. It can then pay off any debts and reimburse shareholders. The greater the difference, the safer that you are
Understanding Valuation Multiples
Deep investing relies on several statistical concepts, the most important is valuation multiples. Valuation multiples are essentially one financial metric of a company compared to another metric. Valuation multiples can be understood in terms of price-to-earnings (P/E) ratios and is a way to roughly judge the intrinsic fair value of a particular security.
For example, say that an analyst determines that they can earn $10 per share of company XYZ. Further, let’s say that company XYZ current market price to earnings ratio is 15. Multiplying the ratio by the estimated earnings should give you a rough estimate of the fair value of a security. In our case, a fair value would be $10 x 15 = $150. The idea is to buy this stock if the market value is significantly below the estimated fair value.
There are several other valuation multiples that you can use, depending on which investment factors you think are the most relevant. Other common types of multiples used to assign market value include enterprise value (EV), which is essentially a measure of earnings before interest and taxes. Graham himself was concerned primarily with the price-to-earnings ratios and market value to book value (shareholder equity) ratios.
What Are the Main Risks of Deep Value Investing?
Some have criticized deep investing as too mathematical and not sensitive enough to other factors that determine stock growth. A stock valuation should include things such as a company’s competitive advantage or management and leadership. The argument is that ignoring these kinds of aspects ultimately kneecaps your growth potential in the future.
Remember that deep value investing is should rely on quantitative metrics, sometimes to the exclusion of other factors. This can lead to the situation where you buy into a company that, on paper, has great financials and fundamentals but, in practice, is just not very good. For people like Graham, this did not matter as the earnings ratio per share was the most important valuation metric.
All investing is subjective at the end of the day. However, deep value investing seems to rely heavily on subjective notions of intrinsic value. The problem is different deep value investors will gauge intrinsic value differently, and many would say that judging intrinsic value is something you can only get good at through practice and refinement of your intuition.
What Is the Difference Between Value Investing and Deep Value Investing?
At the end of the day, deep value investing and value investing share a common core, but differ in a matter of degrees. Deep value investing can be seen as a kind of value investing that has focus on getting deep discounts on stock, regardless of the current business status. In a lot of ways, deep value investing is an extremely contrarian investment philosophy as it actively seeks to find stocks that nobody really cares about that have more value than they let on.
Value investing, in contrast, is much more conservative in its judgments and tends to focus on companies that present a good margin of safety. Stocks that value investors pick might not be optimal according to the rest of the market. However, those deep value investors choose are even less popular.
Who Are World Famous Deep Value Investors?
Perhaps the most famous deep value investor is the father of the method himself, Benjamin Graham. Graham’s protege Warren Buffett takes advice from Graham’s classical approach, though he notably differs in some key respects.
Final Thoughts on Deep Value Investing
Dep Investing is an interesting approach to the stock market and is an investment strategy. It is gaining steam as a way to beat the market. Investors can use a deep value investments strategy to get a large financial discount on stocks at a low price. They can also take advantage of that great value. A multiple ratio is of use when it comes to estimating intrinsic value and comparing it to stock price. At the end of the day, investing in deep value investment strategies is a good way to take advantage of a business that is trading for less money than its book value.