What is value investing?

This text is not intended to replace the many published studies and books on this topic, but rather to show practical valuation options for equities within a manageable framework.

Value investing is one of the key disciplines in the world of investing. Well-known value investors include Warren Buffet, Benjamin Graham (who is also regarded as the founder of value investing), David Dodd and Charlie Munger [1]. Put simply, "value" is where the value of something is higher than the price to be paid for it. The simple form is therefore: value = value > price. This sounds simple, but is more challenging in practice. From the perspective of value investors, assets are often wrongly over- or undervalued. This can arise for a variety of reasons, for example because pricing in the markets is not always efficient and, according to Benjamin Graham, investors sometimes behave irrationally.

The simple part of the formula is determining the price. In the case of listed shares, you can determine the current price daily via the stock exchange information system. To do this, you take the current market price and multiply it by the number of shares the company has issued. This results in the market capitalisation of a company. This reflects the value of the equity [2]. The more difficult part is how to determine the value of the respective company. There are many different approaches: Capitalised earnings value, net asset value, discounted cash flow methods (DCF) are some common derivation options. In the following lines, I will discuss the capitalised earnings value method in more detail. However, the other two are explained briefly:

The substance method can be used, among other things, where the overall company consists of several individual parts and or investments, which can also be valued individually. If the calculated sum of the individual parts is higher than the current price, this could indicate an undervaluation.

The DCF method is very complex. It is often used by bank analysts. They rely on the fact that they can correctly estimate the future development of the company based on their knowledge of the company. They estimate the future cash flows of a company over several years and discount these to the current point in time. The sum of these cash flows forms the value of the company from the analyst's point of view. A popular saying attributed to several people is, with a twinkle in the eye: "Forecasts are difficult, especially when they concern the future."

But is it also possible to look back instead of using complex models of the future? We think that looking backwards can also be very helpful. The big advantage of this is that we can find the relevant published figures by simple means. Many companies have been around for a very long time and have survived several cycles. If we assume that the company and its business model will remain viable in the coming years, it is always worth taking a look back. The past-oriented capitalised earnings value method aims to do just that. It looks at how the company in question has developed over the last few years. This is a company valuation based on sustainable earnings [3] and not on complex profit estimates for the future. The focus can be on the average operating margin achieved, for example. A sufficiently long time horizon should be analysed in which various economic cycles also prevailed.

Simplified example using the capitalised earnings value method:

A listed Swiss company has achieved the following operating margins over the last ten years:

The calculated mean value of 10% is therefore assumed to be the "sustainably realisable income" before taxes. According to management, the company's sales are expected to total around CHF 900 million over the next few years. The debt burden amounts to around CHF 160 million [4]. If we add these figures together, the following picture emerges [5]:

The value of the company calculated in this way is significantly higher than the current market capitalisation. It therefore shows: value > price! It gives the investor an initial indication that there could be an undervaluation or "value" here. In this case, the interested value investor would carry out further analyses, in particular whether the business model is viable and sustainable from his point of view. If he comes to a positive overall conclusion, he will draw up an investment plan to invest in this company in the near future.

Value investors often need staying power. Such undervaluations from the investor's point of view can drag on for a very long time, usually longer than expected. Certain shares live through a kind of "wallflower existence" until, for example, an unforeseeable event draws the attention of many other investors back to the company. Russell Napier, the well-known economic historian, describes this phenomenon as follows: "If you see a thematic boom in the markets (currently centred around artificial intelligence, for example) and are convinced that it can't last forever, but you don't know when it will end: Double the time you think the boom will last based on your analysis and subtract one month from that." [6]

Conclusion: Value investing requires analysing companies and markets as well as a long-term perspective. There are various methods for calculating the subjective value of a company. Value investing requires patience and discipline, as it can often take some time for the value of an undervalued asset to be realised. Value investors look for stable and profitable companies with strong competitive advantages that are trading at a price that does not reflect their long-term prospects. By selecting solid companies at attractive prices, value investors seek long-term capital appreciation and a reasonable return on their investments. Or in the words of value investor Warren Buffet: "Price is what you pay, value is what you get."

Appendix:

List of sources

[1] https://www.valueinvestments.ch/value-investing

[2] To arrive at the "enterprise value", the debt is added to this value and the net cash is subtracted.

[3] Source: Based on Fidecum SICAV Contrarian Value Euroland, short update from July 2023

[4] Source: ch.marketscreener.com

[5] Calculation see appendix, assumed capitalisation rate 8.5%, applied tax rate 20%

[6] themarket.ch/radar/russell-napier-21-lessons-from-financial-history-ld.10995