One of the most dangerous misconceptions in finance is the idea that value investing only involves buying cheap stocks. Buying stocks just because they look cheap can be a quick way to lose a lot of money, and it's not really value investing at all.
Value and intrinsic value
The very idea of value investing is based around the principle of buying a stock at a discount to its intrinsic value. Intrinsic value can mean many things, and all investors will have a different method of computing this key figure.
This is where things can get confusing. Intrinsic value and a low price-book or price-earnings ratios are not the same. Ratios only tell investors how the company is valued compared to its earnings, book value or some other value at one point in time. They do not tell you anything about the underlying business or its prospects.
Just because a stock looks cheap today based on a simple metric does not mean that it always will be. For example, if I were to buy a stock trading at a price-book ratio of 0.3 today, some investors might call this a great deal. But, it's only a great deal if the business is liquidated today and book value is returned to investors. The likelihood of this happening these days is low.
Instead, I may have to wait for the market to revalue the stock higher. This could take months, or it could take years. If it takes years, it matters what happens in the interim. If the firm destroys book value, the stock will actually become more expensive.
This is why trying to distinguish between growth and value is so dangerous. No one wants to buy a company that is shrinking or standing still. Even in the above example, without a catalyst to unlock value, the only way for the value of the business to increase is if management invests back into the operation to grow book value or earnings.
If a company is investing in its operations, the stock will only become cheaper if book value increases. This is how growth stocks can become value stocks. To explain further, we can look back at one of Warren Buffett (Trades, Portfolio)'s most famous investments, Coca-Cola (KO, Financial).
When growth becomes value
When the Oracle of Omaha was buying his investment in Coca-Cola back in 1988, the company reported earnings of $1 billion for that year. Based on the number of shares outstanding at the time, 365 million, the company's earnings per share were in the region of $2.84. Using the average purchase price of $41.81, Buffett bought the stock at a price-earnings ratio of 14.7.
In 2019, the company earned nearly $9 billion. With around 4.3 billion shares outstanding at the end of the year, on a per-share basis, the company earned $2.90. However, based on the number of shares outstanding in 1988, the company earned $24.67 per share. This implies Buffett was buying the stock at a (very far in the future) forward price-earnings ratio of 2.2 in 1988.
This is an incredibly simplistic example, but it is designed to illustrate a point. Growth stocks can become value stocks over time as earnings and book values expand. Of course, the hard part is finding these stocks that can grow year after year.
