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Be a Value Investor

Value investing is the concept of purchasing investments at a price that is below their intrinsic value.  Modern analysis involves projecting free cash flow, discounting cash flows by the risk free rate to determine the value of the company, and then dividing the value of the company by the number of outstanding shares to determine what the price of a share “should be”.  Ideally the price paid for the stock should be less than this with a margin of safety to allow for estimation error.  The risk free or hurdle rate used will be subjective, but should generally be what can be achieved in the market with little to no risk.   

 

Of course, this is not the only factor to determine a suitable investment.  Many expert investors will say it’s better to purchase a “good company” at a fair price than an “ok company” at a discount.  Other important factors to consider include earnings and revenue growth, industry type (growth versus mature), and management effectiveness.   It is also easier to determine the value of a company if cash flows are predictable.  If cash flows are volatile this will increase the likelihood of estimation error and your investment risk. 

 

This same approach of value investing can also be applied to real estate investing.  Appraisers will often value commercial estate by doing a discounted cash flow analysis.  The same approach can be taken towards residential real estate investing, or alternatively you can also compare the purchase price of the home to what it would cost to build new.  The value of a residential property isn’t strictly a function of the income it can produce, and there are still some areas that you can purchase a home at or below the cost of construction.  If that particular market has positive trends in key areas such economic growth, unemployment, and infrastructure development that is usually a good sign.

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