Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 17

Value investing and valuing a business

Originating from the economist and investor Benjamin Graham, the philosophy of value investing has been a strategy employed by some of the most successful investors in history including Warren Buffet and David Dodd. This approach revolves around investing in stocks trading at a discount to their intrinsic value but there is always one critical question inherent in this investment philosophy; what valuation multiples do you use to identify the intrinsic value of a company?

Selecting valuation multiples

Unfortunately there is no single method of valuation and it is subjective whether an investor places more importance on current assets and earnings or on future cash flows and growth prospects. Over the years there have been opposing thoughts. Modern Portfolio Theory argues that due to the Efficient Market Hypothesis, all stocks trade at their fair value and it is impossible to identify undervalued shares. Yet it is widely agreed that value stocks have consistently outperformed growth stocks in the long term and some of the most successful investors have continued to outperform the market by identifying companies that are trading at a significant discount to their intrinsic value.

Keeping in mind that there are a range of multiples and valuation models that can be employed in value investing, there are some key factors that are often considered in valuing a business.

When we qualitatively analyse the quality of a business, the fundamental drivers of value include the company’s management team and their experience in the respective sector, the company’s strategy and plans in place for the company’s expansion. Translating this to quantitative drivers, return on equity and capital, debt to equity ratios and cost of capital come into play. A value investor should also take into consideration accounting policy differences which can skew profit multiples, and can lead to misleading valuations of companies in comparison to its sector. Depreciation, goodwill, provisions and deferred tax should be considered. As a result, a company’s cash flow is a good metric for valuation as it is free from accounting distortions and its EBITDA is a suitable measure to assess profitability.

The Price to Earnings (PE) Ratio is one of the most common multiples used by the retail investor to indicate if a share is over or undervalued but this can be misleading for a few reasons:

  • earnings are subject to different accounting policies
  • different capital structures will lead to a gearing effect on the earnings which will skew results for different companies
  • a low PE could be a sign of negative market sentiment towards the stock rather than a reflection of the stock being undervalued.

The Price to Book Value, which represents a company’s share price over its book value, is often used to value a business where value is generated through its tangible assets. This is where Return on Equity comes into play. Financial stocks, especially banks, are often valued using the Return on Equity ratio due to their high levels of leverage from deposits coupled with significant assets through loans. Return on Equity can reflect how efficiently a company utilises shareholders’ equity to produce profit, as well as how effective the company manages its debt and asset turnover. A company with a consistently increasing Return on Equity and a decreasing debt level is often a sign of an effectively-managed business.

After analysing these key valuation multiples, investors should gain an in-depth understanding of the company’s business model and its sector to make a more informed investment decision.

What to look for in listed companies

My golden rules for investing are:

  1. Make informed and educated investment decisions
  2. Know why you are buying shares in the company
  3. Do not speculate
  4. Invest only when there is an opportunity
  5. Invest in quality companies with great future prospects
  6. Understand the business before investing
  7. Have an exit strategy
  8. Have patience and discipline.

Value investing is a strategy used by some of the most renowned investors in history and is a proven approach that can help the medium to long term investor identify undervalued businesses. The market is dynamic and volatile and investors should have a clear strategy and direction before making any investment decision. An individual should invest in quality stocks that are trading below their intrinsic value with a target in mind.

Michael Kodari is Managing Director of Kodari Securities (KOSEC).



Quality over quantity: a lesson of value

Don’t go swimming naked for a short term thrill


Most viewed in recent weeks

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Two strong themes and companies that will benefit

There are reasons to believe inflation will stay under control, and although we may see a slowing in the global economy, two companies should benefit from the themes of 'Stable Compounders' and 'Structural Winners'.

Latest Updates


Stop treating the family home as a retirement sacred cow

The way home ownership relates to retirement income is rated a 'D', as in Distortion, Decumulation and Denial. For many, their home is their largest asset but it's least likely to be used for retirement income.


Hey boomer, first home buyers and all the fuss

What is APRA worried about? Most mortgagees can easily absorb increases in interest rates without posing a systemic threat to the banking system. Housing lending is a relatively risk-free activity for banks.


Residential Property Survey Q3 2021

Housing market sentiment has eased from record highs and confidence has ticked down as house price rises slow. Construction costs overtook lack of development sites as the biggest impediment for new housing.

Investment strategies

Personal finance is 80% personal and 20% finance

Understanding your own biases and behaviours is even more important than learning about markets. Overcome four major cognitive biases that may be sabotaging your investing and recognise them in others.

Where do stockmarket returns come from over time?

Cash flow statements differ from income statements and balance sheets, and every company must balance payments to investors versus investing into the business. Cash flows drive the value of the business.

Fixed interest

How to invest in the ‘reopening of Australia’ in bonds

As Sydney and Melbourne emerge from lockdown, there are some reopening trades in the Australian credit market which 'sophisticated' investors should consider as part of their fixed income portfolios.


10 trends reshaping the future of emerging markets

Demand for air travel, China’s growing middle-class population, Brazil’s digital payments take-up, Indian IPOs, and increased urbanisation are just some of the trends being seen in emerging economies.



© 2021 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.