The Basic Principle of Value Investing

Value investing is the art of appraising the worth of a business and distinguishing it from the price the business is selling for in the market. Warren Buffett said, "Price is what you pay for; Value is what you get."

Benjamin Graham, the father of Value Investing, and Warren Buffett's mentor, extended this concept to the stock market by illustrating the following parable. From Intelligent Investor:

"Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very indeed very obliging. Every day he tells you what he thinks your share ownership is worth and furthermore offers either to purchase you out or sell you an additional share of ownership on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.

If you were a prudent investor or a sensible businessman, you would not let Mr. Market's daily communication determine your view of the value of your share ownership in the business. You may be willing to sell out to him when he quotes you an extremely high price, and equally willing to buy from him when his price is ridiculously low. But at the rest of the time, you would be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position."

Put another way, one must distinguish "quotational loss" versus "permanent loss of capital". The former is movement in the price of a stock due to psychological sentiment, liquidity issues or other factors. The latter is a "permanent damage" to the franchise of the business due to fundamental factors - such as product obsolescence, permanent changes in market demand for a product, losing market share to a better competitor, changes in the habits of customers, upcoming product substitutes.

This all sounds simple. But it begs the question: How does one know if the value of a business is changing? The answer is not to look at the stock price, but to do your own research. For example - try the product, visit the store, read business and trade magazines, or ask friends who are customers of the business. The other way is to gather facts and data points about the financial state of the business.

With the internet, fundamental research on stocks has never been as widely available and convenient as before. You can go directly to the company's SEC Filing, pick up a chart, news headlines, get analyst's estimates and ratings, earnings history, financial statements and many more. You can also do market research on government web sites and other trade association web sites. Finally, if you have the time, you can participate in many active communities and discuss with others about a product, a stock, etc.