The value approach: buying below what it is worth

The value approach has two steps, and the second is usually skipped.

Step one: find the cheap

Screening on multiples: price relative to earnings, equity, cash flow — P/E: what it is and why low does not mean cheap, EV/EBITDA: when it is more honest than P/E.

That is a mechanical operation available to any screener.

Step two: understand why it is cheap

Every cheap security has a reason for being cheap. Sometimes the market is wrong; more often it is not.

The question is framed like this: what does the market believe about this company, and why do I believe otherwise. Without an answer, step one produces not a list of undervalued securities but a list of companies with problems.

The value trap

A company in structural decline gets cheaper for years and looks cheap throughout. The multiple falls along with the business, and buying "at the bottom" repeats many times over.

What to look at besides multiples

Leverage — Leverage: how much debt is too much. Cash flow rather than profit alone — The cash flow statement: why it is more honest than profit. The quality of corporate governance — Corporate governance: why a minority shareholder should care.

Horizon

The value approach demands patience: a gap between price and value can persist for years. An investor without a horizon exits before the hypothesis plays out.

Related: Growth and value: two different reasons to buy.