Value Investing and Importance of Replacement Cost

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April 5, 2022

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What is Value Investing?

In the 1920s, Benjamin Graham, an American economist, investor, and lecturer, pioneered a new style of stock investment called ‘Value Investing.’ He is renowned as the “Father of Value Investing,” and his approaches are still followed by notable investors like Warren Buffet and Peter Lynch. By simply analyzing firms with fine precision, he was able to build an enormous fortune while minimizing his risks.

Value investing is really a combination of two concepts: undervaluation and overvaluation. When a stock’s price is lower than its inherent worth, value investors consider it undervalued. Investors, on the other hand, regard a stock to be overvalued if it trades at a price higher than its intrinsic value.

How Does Value Investing Work?

The value investing approach is to buy stocks when they are inexpensive or on sale, and sell them when they reach or exceed their actual or intrinsic value. Accounting for a margin of safety when trading in value investing companies is another criteria that value investors adhere to. You can check our youtube video here, where we have explained the importance of value investing and the importance of margin of safety.

What is Replacement Cost?

The current market price an organisation would have to pay to replace an existing asset is defined as replacement costs in accounting. This is in contrast to the value of a book. The historical purchase price of the asset, less accumulated depreciation, is its book value.

Understanding Replacement Cost for Value Investing

Investing can be a tricky business. It has no straightforward trajectory that could be followed, rather it depends heavily on the various external and internal factors – making it one of the most dynamic areas of finance. This is where value investing comes into place. Investors that practise value investing actively seek out equities that they believe are undervalued by the market and/or trade for less than their fundamental worth. Value investing, like any other sort of investing, differs in execution from person to person. There are, nevertheless, some universal criteria that all value investors adhere to. 

Famous investors such as Peter Lynch, Kenneth Fisher, Warren Buffett, Bill Miller, and others have outlined these principles. They look for mispriced stocks and try to profit from a possible reversion to the mean by reviewing financial statements.

Looking for mispricings in the value of stocks comes with difficulties of its own. Many investors rely on using replacement costs as a means of comparison with the market value to make more informed decisions. 

To make the understanding of replacement cost as an investing strategy easier, let’s proceed through an example. Most of the asset heavy business models take into account replacement costs of their plant and machinery for better valuation. 

If a firm purchased a machine for Rs 1,000 crores five years ago, and the asset’s current value, minus depreciation, is Rs 300 crores, the asset’s book value is Rs 300 crores. However, at current market values, replacing that equipment may cost Rs 1,500 crores. As a result, the replacement cost would be far greater than the book value. 

Proceeding further with this, if we conceptualize a steel company with large capacity steel plants, we can value the company’s assets through its replacement cost – the amount of money required to replace an existing plant with an equally valued one. In other words, it is the cost of obtaining a replacement steel plant for a company’s current steel plant. If the steel plant was brought at a value of Rs 1000 crore five years ago, and the depreciation of Rs 700 crores has been accounted for, the book value of net assets of the company is Rs 300 crores. After analysis, we find that the replacement cost of the steel plants is Rs 1500 crores. The current market value of the company;s assets stand at Rs 1200 crores which is less than the replacement cost, thus making the company undervalued and suitable for value investment.

We had written a blog on SAIL which is a perfect example of replacement used in value investing. You can check the blog here

Tobin’s Q

The Q ratio, commonly known as Tobin’s Q, is calculated by dividing a company’s market value by the replacement cost of its assets. To put it another way, it’s a method of determining if a company or market is overvalued or undervalued.

A low Q ratio (between 0 and 1) indicates that the cost of replacing a company’s assets exceeds the value of its shares. This suggests that the stock is currently undervalued. A high Q (more than 1), on the other hand, indicates that a company’s stock is more expensive than the replacement cost of its assets, implying that the stock is overvalued.

Conclusion

Asset-heavy businesses like steel, cement, airline, and automotive can be valued by taking into account the replacement cost as it gives them the business a fair value. If the historical cost of a company’s asset differs significantly from its current market price, the replacement cost may raise the company’s worth. For example, if the corporation bought a building in an up-and-coming neighborhood 20 years ago, the historical cost of the structure is substantially lower than its replacement cost. As a result, the company is worth more than its balance sheet indicates. 

The CEO of Berkshire Hathaway, Warren Buffett, is possibly the most well-known value investor of all time. The S&P 500 has achieved a total return of 23,454 percent from the time Buffett gained control of Berkshire in 1964 until the end of 2020. Berkshire Hathaway’s total return during the same time period was a mind-boggling 2,810,526 percent. The strong potential and influence of value investing are leading the way for investors to make better, and more informed decisions. Because if done correctly, value investing can produce above-average returns in the long run.

Very important note: The objective of this blog is to share knowledge and info about multibagger ideas/opportunities. Neither is this trading website nor an analyst website nor a Buy/Sell call website. For stock market success, always do your homework, own analysis, and make your own decisions.

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The author of the blog Mr.Suyog Dhavan is a Full-time Investor / Value Trader and Value investing/Trading Mentor. His style of Investing is inspired by Mohnish Pabrai, Peter Lynch, and Porinju Veliath. He is the founder of Strategic Alpha Wealth, A Premier stock market mentorship firm with a mission to touch the lives of 1Lakh people through its mentorship program.

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