Have you ever tried to compile a list of the most successful investors of all time? If you're like most of us, the top of your list included Warren Buffett, Benjamin Graham, and Peter Lynch. But what, exactly, made these investors great? And more importantly, how did they do it?

Though each of these great investors had their own distinct approaches to the market, they had one thing in common: They are value investors. And because being a value investor involves little more than a stack of financial statements and the desire to know a company inside and out, anyone can learn the principles that guide the world's greatest investors.

Momentum investors come and go, but value investors like Buffett and Lynch have exhibited incredible staying power over the course of their careers. Though all of these great men had a few cold streaks, we can not think of another single approach that has proven to be more effective than value investing over the long haul.

In the next few pages, we'll lead you through some of the key concepts of value investing, along with an example of how Mr. Buffett has put value investing principles to work.

Why Choose Value Over Growth?

A ton of academic research has been published on value vs. growth, offering us some facts to back up the assertion that value stocks outperform growth over the long term.

According to research firm Ibbotson Associates, from December 1968 until December 2002, value stocks delivered an average annual return of +11.0%. By comparison, growth stocks returned just +8.8% and the S&P 500 managed a mere +6.5% annualized return.

The Russell Investment Group provides us with another great example. The widely followed Russell 2000 Index has two cousins: the Russell 2000 Growth Index and the Russell 2000 Value Index.


As you can see, stocks belonging to the value camp dramatically outperformed their growth counterparts. Aside from a blip on the chart just before the dot-com bust, a time when growth stocks were unusually hot, value stocks have consistently outpaced growth stocks. Investing in value over this time period would have turned a hypothetical $10,000 investment into nearly $60,000 -- more than double the return of growth stocks.

Value stocks also handily outperformed growth stocks throughout the bear market of 2000 to 2002, and it is not unreasonable to expect that value stocks will do the same in the current market as well. After all, during times of economic and market uncertainty, investors traditionally flock to quality value stocks for the safety and stability they provide. And contrary to popular belief, value stocks deliver strong gains during bull markets as well. That's why value stocks are truly seen as stocks for the long haul.

Focusing on value makes sense for most investors. Hot momentum and growth stocks grab the headlines, but over the long run value consistently wins out. Before we go any further, let's get a better understanding of the term 'value.'

Cash Flows Are King

Investors choose to purchase stocks for a variety of reasons. Some buy into the compelling and enticing narratives that companies and analysts push -- a new blockbuster drug, an emerging technology, or an exciting new product. Others seek out firms with a dominant brand name, attractive growth prospects, or substantial underlying assets.

Nevertheless, when purchasing a stock, it's important to remember that you're not buying a story, a manufacturing plant, a management team, or a factory full of equipment.

At its very core, every stock investment is the purchase of a stream of future cash flows. Although cash can sometimes come from the sale of certain assets (or the entire business itself), it primarily comes from a firm's operating activities.

With this in mind, a hot momentum stock may have a great story to tell, but ultimately that story will prove meaningless if it doesn't lead to the generation of solid annual cash flows. In the end, it's cash that is needed to fund dividend payments, repurchase shares, and reinvestment in the business.

From time to time high-flying growth companies blossom into cash-generating machines like Microsoft (Nasdaq: MSFT). However, for every hot growth stock that matures into a cash cow, there are countless others that fall into obscurity, delivering nothing but heartache for investors. Even worse, as we saw following the dot-com bust, many of these companies can even end up in bankruptcy.

Calculating Cash Flow Ratios

While value investing can be highly profitable, no one ever said it was easy.

Uncovering mispriced stocks can be a time-consuming and research-intensive task. In the case above, for instance, Buffett undoubtedly put in months of research delving into Clayton's background. Furthermore, even if a value investor is spot-on with his assumptions, it may take a while for the rest of the market to catch up -- meaning undervalued stocks can remain that way for extended periods of time before other investors finally get with the program.

Nevertheless, as the historical returns show, hard work and patience can be well worth the effort. While there is no single metric that will allow investors to uncover the best value plays, a couple of ratios can help jumpstart the analysis needed to find solid candidates.

First and foremost, don't get flustered when you see equations or formulas. One of the hallmarks of value investing is that you don't need really complex calculations to do your analysis. Most of the calculations only involve simple arithmatic. And if you take just a bit of extra time to understand the relationships among the variables, you will quickly gain a deeper understanding of the business you're evaluating.

Cash Flows Don't Lie
Cash Flow is one of the most important, if not the most important, concepts in valuing a stock. As we already mentioned, the price of a stock today is simply a sum of its future cash flows when those cash flows are put in today's dollars.

Technical analysts aside, most investors buy a stock because you they believe the company will pay them back in the future via dividend payments or stock repurchases. A company can only pay you back if it generates more cash than it spends. Hence the importance of calculating free cash flow.
With this in mind, value-conscious investors should always examine a firm's cash flows before making any investment.

Some of the measures we'll talk about later, including P/E ratios and return-on-equity, use line items from the income statement. The income statement is incredibly important when anayzing a firm, but because of the nature of accounting rules, income statement measures like net income and earnings per share may not be indicative of the amount of cash a company is generating. Companies can (and do) use a variety of accounting tricks to manipulate or distort their earnings from quarter to quarter.

By contrast, Cash Flow measures the actual cash going in and out of a company over a certain period of time. Cash flows are objective and can't be easily manipulated.

Cash Flow from Operations / Enterprise Value
Keeping that in mind, the first tool we'll examine is the cash flow-to-enterprise value ratio, also known as the operating cash flow yield (OCF yield). This ratio gives us a sense of the amount of cash a company is generating each year relative to the total value (both debt and equity) investors have assigned to the firm.

Cash flow from operations (CFO) is found, not surprisingly, on the statement of cash flows. It is a measure of the cash generated by the business part of the business. It does not take into account any cash raised by selling assets (cash flow from investing) or by borrowing or issuing shares (cash flow from financing). In the long-run, the business must be able to make money from its operations.

The denominator of the ratio is enterprise value (EV). EV is a way of adjusting market capitalization to more accurately reflect a firm's true value. It is calculated by taking a company's market capitalization (price per share times the number of shares outstanding), then adding the outstanding debt and subtracting the firm's cash balance. This makes EV an excellent reflection of the total value an investor would receive if he/she purchased the entire firm -- the investor would have to pay off a firm's debt but would get to keep the cash on the books.

By dividing a company's operating cash flow by its enterprise value, we're able to calculate the firm's OCF yield. This measure reflects how much cash a company generates compared to the total value investors have placed on the firm. All things being equal, the higher this ratio, the more cash a company generates for its investors. Underpriced companies with high OCF yields can end up being excellent value stocks.

Discounted Cash Flow (DCF) Analysis
DCF modeling is a rather sophisticated analytical tool that many Wall Street pros use to gauge a firm's intrinsic value. The process involves forecasting a firm's future cash flow stream, then discounting those cash flows back to today's dollars using a rate of return high enough to compensate investors for the risks they are taking. By adding up the present values of all future cash flows and dividing by the current number of shares outstanding, we come up with an estimate of the firm's intrinsic value per share.

As might be expected, the numbers that come out of this calculation are only as good as the numbers that go in -- inaccurate growth projections and unrealistic discount rates can leave you with intrinsic value calculations that are wildly off base. As mentioned earlier, to offset this risk, most value investors build in a wide margin of safety before investing. In other words, they might not purchase a stock with a $50 per share intrinsic value unless it was trading at $40 or below. The higher the degree of uncertainty, the larger the required margin of safety.

Now that we've introduced you to cash flow analysis, let's look at some of the value-based ratios that complement it in our search for value.

Is the Price Right?

Value investors are known for being cheap.

They are always on the lookout for companies that are trading for much less than what they are actually worth. More specifically, value investors look for situations in which the future stream of cash flows a company is likely to produce has been mispriced by the market.

Since the calculation of what a stock is actually worth (its intrinsic value) is made up of assumptions, it's extremely difficult to nail down a stock's true intrinsic value. To protect themselves against valuation error, most value investors rely on the important concept of margin of safety.

For example, an analyst plugs her assumptions into a simple cash flow model that she's put together. Her model says that Company X has an intrinsic value of $10 per share. Today, Company X trades at $9.50 per share. She could buy the shares now, but in order to protect herself against the possibility that she's calculated the wrong price, she decides to wait until the stock hits $8 before she buys it. She has built in a margin of safety.

The concept of a margin of safety is incredibly valuable because investors can use it to minimize their downside risk and potentially earn above average returns -- even if they have slightly overestimated the stock's true value.

Value investors believe that the market can mis-price stocks as a result of short-term concerns or misinformation spread among the crowd. When those fears dissipate, the stock can recover and rally toward its true intrinsic value -- yielding huge gains to those that looked beneath the surface.

To see this methodology in action, look no further than Warren Buffett -- whose track record offers a plethora of examples, including the following.

In 2003, Buffett purchased Clayton Homes, a builder of manufactured homes. Prior to the acquisition, Buffett believed the market was undervaluing Clayton because it was overemphasizing the manufactured-housing industry's volatile history.

During booms in the real estate market, manufactured-housing companies typically engaged in overly-aggressive lending policies. When the market would slow, these same companies would struggle to collect on a portfolio of ill-advised loans (similar to the recent housing market crash).

When Buffett picked up Clayton, the Fed was preparing to raise interest rates. Many investors on Wall Street felt the boom-and-bust cycle was about to repeat itself. Conventional wisdom at the time said manufactured homebuilders would get stuck holding a bag of bad loans.

However, Buffett knew that Clayton was an extremely well-run company. In sharp contrast to many other firms in the industry, Clayton's management prided itself on being conservative in its lending practices. The company tended to seek out higher-quality borrowers who wouldn't default when times were bad, even if it meant turning away potential customers.

In this case, Buffett managed to uncover a stellar value investment simply because Wall Street had painted Clayton with the same brush as the rest of the industry. Buffett's assessment of Clayton's value was right on target, and as a result, he managed to earn tremendous returns by purchasing the stock at a steep discount to its intrinsic value.

Calculating Value Ratios

By itself, a stock's price tells us very little. It must be placed in the proper context. As a value investor, you can use a host of ratios to determine whether a stock is trash or treasure.

Price-to-Earnings (P/E)
The price-to-earnings ratio provides us with an important measure of a company's stock price in relation to its earnings. As you may already know, the P/E ratio is calculated by dividing a firm's current stock price by its earnings per share (EPS). The result essentially tells us how much investors are willing to pay for each dollar of the company's earnings.

All else being equal, the lower a firm's P/E ratio, the better value the stock is relative to its current earnings base.

While the math behind this measure is fairly straightforward, you do have several variations to choose from. Trailing earnings are based on the company's actual earnings over the previous 12-month period. Forward earnings are based on analysts' earnings estimates for the year ahead (or even further in the future).

We prefer to examine both trailing and forward values, as they can both yield important clues. For example, if a company's forward P/E is well below its trailing P/E level, then this may be a sign that the stock is undervalued in terms of the future earnings analysts are projecting.

It's important to remember that P/E ratios are meaningless when examined in isolation and can be misleading when used to compare stocks in different industries. Because different industry groups don't share the same fundamental characteristics, they tend to trade within different average P/E ranges. It wouldn't be appropriate to measure the P/E of say, a regional bank, against that of a software firm.

Finally, growth rates must also be taken into consideration. A company trading at 20 times earnings and posting reliable earnings growth of +40% per year might be a much 'cheaper' stock than a company with flat growth that's selling for 10 times earnings.

To take earnings growth into account, we'll take a look at the PEG which we explain below.

P/E-to-Growth Ratio (PEG)
By incorporating a firm's expected future growth into the equation, PEG ratios help us to eliminate one of the major shortfalls of pure P/E comparisons.

As a simple rule of thumb, stocks that sport PEGs of less than 1.0 are potentially good values.

Although the PEG ratio is an extremely useful measure, it's far from foolproof. Very high-growth companies can often have PEG ratios above 1.0 and still be decent long-term values. Don't fall into the trap of believing that all companies with PEGs under 1.0 are good investments. After all, unrealistic growth estimates can easily throw off the calculation. With these potential pitfalls in mind, use PEG to identify potential quality value stocks, but use it in conjunction with other measures to decide whether or not the firm is a true value.

Return-on-Equity (ROE)
ROE is an excellent tool for value investors and is a favorite of Mr. Buffett. The calculation of ROE is simple: divide a company's net income by its shareholder's equity. This ratio measures the profit a company produces relative to shareholders' investment in the firm.

Net income is often referred to as the 'bottom line' since it's actually the bottom line on an income statement. Shareholder's equity is listed on the balance sheet, and it is an accounting measure that estimates what would be left for the owners if all the assets were sold and the debts were paid off.

When searching for value-oriented investment ideas, it makes sense to look for companies that have shown stable or rising ROEs in recent years. However, keep an eye out for company's that have one abnormally strong year or who have booked a one-time gain, as its net income figure may be temporarily inflated. Many tech companies, for example, produced enormous ROE in 2000, only to see reduced profitability (and ROE figures) the next few years.

There is also an important relationship between ROE and debt. By taking on higher and higher debt loads, companies can substitute debt capital for equity capital. Thus, companies with large debt loads will have higher ROE than companies with a more balanced use of leverage.

By and large, look for companies that have ROE figures in the mid-teens or better -- roughly the historical average of the S&P 500.

Putting It All Together

Investing is always a delicate balance of art and science.

To pinpoint sharply undervalued stocks, most investors begins by screening for companies that score well in the key valuation metrics discussed earlier. However, don't assume that a list of names that filter through ratio analysis screening is all that is necessary to identify winning value stocks. Each stock generated by those screens needs to be carefully evaluated, and a close examination of non-numerical data should also be weighed.

For example, in the Clayton Homes scenario above, Buffett took a hard look at the company's management team before investing. It's a good idea to dig into the background of a company's management and executive team before investing. What credentials or accomplishments do they bring to the job? Do they have prior industry experience, and if so, is their track record commendable? Have they aligned their interests with the rank and file by purchasing shares in the company?

Next, consideration should also be paid to the company's industry and whether or not the firm has a recognizable edge over its peers. Value investors often call this comparative advantage a 'moat.' Try to invest in companies that benefit from a variety of distinct and defensible competitive advantages.

Advantages can take the shape of a powerful brand name, a unique product, or even a patented technology. Remember, companies with sustainable competitive advantages are much more likely to maintain a high level of profitability than those without them.

It is also a good idea to determine whether a company operates in a cyclical market. Some firms -- such as automakers -- typically see their fortunes rise and fall with changes in the economy. The performance of these firms is often tied to broad macro-economic factors; they may look attractive when times are good, but they're also vulnerable to economic slowdowns. In other words, ask yourself whether or not the company's economic moat is wide enough to protect the firm's profitability under difficult conditions.

Finally, learn as much about a prospective company's operations as possible. This includes a thorough look at its industry, its vendors, its customers, its competitors, etc. Dig through old press releases posted on financial websites. The company's most recent quarterly and annual reports are also required reading.

Remember, the most valuable articles or bits of information can run contrary to your opinion on a company. In other words, don't ignore warning signs jump because they challenge your thesis on a stock; instead try to poke holes in your own arguments. This will help eliminate costly investing mistakes and allow you to invest with more conviction.

Successful value investing doesn't necessarily involve uncovering an abundance of potential picks; the key is to be right when you do find a good one. When you've finally made up your mind, invest with confidence and hold for the long term.