The idea is simple - buy stocks that are undervalued, because value can and will only be realised overtime. Or the popular saying "Buy a dollar for eighty cents".
However, the execution value investing varies. So the valuation techniques and the corresponding valuations are and will be different.
For me, I summarise it into 3 equations.
The Compounding Equation
Pr * (1 + R)^NCompounding is a very important concept in investing because it accelerates wealth with time. Here, Pr represents the amount of money invested (the Principle), R is the Rate of Return, and N is the number of years invested.
The equation assumes that the returns generated from R is reinvested. For a principle of $100 (Pr = 100), compound at a rate of 10% per year (R = 0.1) for 10 years (N = 10) we would get about $259. The absolute value does not look impressive, but the principle has grown over 2.5x (or 250%), averaging out about 25% a year. And we started out with only 10% in this example.
These are the three variables that make the magic work. There is a choice for each Pr and N, that is, we can choose how much we wish to invest and for how long we wish to stay invested. It is the R that is the challenging part because it really depends on the quality of the business, and I think this is the essence of value investing.
My blog is about finding this R reliably.
The Accounting Equation
A = L + E
This simple equation that quietly resembles a beverage is the next important equation. A stands for Assets, L Liabilities and E Equities. These three entities form the basis of a Balance Sheet. The equation basically means that the assets that a company owns must be supported by some form of liability (debts and loans, for example) or from investors' money (equities).
From this equation, we can also interpret that Creditors (from the L part) and Investors (from the E part) have rights to claim assets. To put it into the investors (that's us) perspective, we can arrange the equation and it will be clear.
Assets are generally regarded as necessities to conduct business, which general revenue, and thus profits. Hence assets has to be studied for their quality and also effectiveness, because more assets may not directly equate to better prospects. The next equation is linked to the effectiveness of the deployment of assets.
From this equation, we can also interpret that Creditors (from the L part) and Investors (from the E part) have rights to claim assets. To put it into the investors (that's us) perspective, we can arrange the equation and it will be clear.
A - L = EThat's right. Investors can claim whatever that is left after deducting liabilities - debts and taxes have to be paid first, unfortunately. Hence as an investor, we would want to consider a company with maximal assets and minimal liabilities. In another words, we are looking for financially strong companies.
Assets are generally regarded as necessities to conduct business, which general revenue, and thus profits. Hence assets has to be studied for their quality and also effectiveness, because more assets may not directly equate to better prospects. The next equation is linked to the effectiveness of the deployment of assets.
The Income Equation
P = R - ExHere, Profit (P) is Revenue (R) less Expenses (Ex). To be profitable, R must be maximised, and Ex minimised. A company's profitably by and large depends on how they generate revenue through deployment of assets and minimise expenses through efficient business conduct. So it goes back to the efficiency of assets deployment.
The simplest way to assess the efficiency is using the ratio P/A or the return on assets.
These three equations look simple, but they have profoun impact on how we look at companies financials and our decision on whether a company's stock is investment-worthy. And I shall attempt to discuss them in depth in my future entries.
Such is value investing.
~ZF
