What valuation and investing styles are

Valuation is the process of estimating an asset's true value to compare with the market price. From valuation approaches, different investing styles form, notably value investing and growth investing.

The main concepts

  • Intrinsic value: an estimate of an asset's true value based on its ability to generate future cash flows, independent of the current market price.
  • Discounted cash flow (DCF): a valuation method based on the idea that an asset's value today equals the sum of its future cash flows brought back to the present. It's a foundational approach but depends heavily on assumptions.
  • Value investing: seeking to buy assets priced below their estimated true value, waiting for the market to recognize and correct.
  • Growth investing: focusing on high-growth companies, accepting a higher price for large future expectations.

How to apply it

Valuation doesn't give one absolutely correct number, but a range of estimates depending on assumptions; use it to sense a margin of safety rather than an exact price. Value and growth styles aren't mutually exclusive; many combine them, seeking well-growing companies still reasonably priced. The common thread is buying based on value, not buying just because the price is running.

A concrete example

A value investor estimates a company's true value, then buys only when the market price is significantly below that estimate, creating a margin of safety in case the estimate is wrong. A growth investor is willing to pay a higher price for a fast-growing company, betting on the future. Both rest on a view of value, differing only in perspective.

Common mistakes

  • Treating a valuation number as absolutely precise, forgetting it depends heavily on assumptions.
  • Buying just because the price is low without asking why it's low, falling into a value trap.
  • Overpaying for growth based on baseless expectations.
  • Ignoring a margin of safety, leaving no room for being wrong.

FAQ

  • Does valuation give a precise number? No. It gives a range of estimates depending on assumptions; its value lies in creating a margin of safety, not precision.
  • Is value or growth investing better? Neither is absolutely better; each suits different periods and temperaments, and they can be combined.
  • What is a margin of safety? The gap between your buy price and estimated value, protecting you when your estimate is wrong.

Checklist

  • ☐ Am I treating valuation as a range, not an absolute number?
  • ☐ Am I leaving a margin of safety in case my estimate is wrong?
  • ☐ Am I buying based on value, or just because the price is running?
  • ☐ If buying growth, are my expectations well-founded?