Value investing is a strategy that involves seeking out and buying stocks that are trading at a market price lower than their book value or true value. In other words, you are looking for stocks that are “on sale” or worth more than their current share price. When the stocks reach or rise above their true value, you sell them for a profit.
If you are looking to add value stocks to your portfolio, the time is now. However, ensuring successful investments requires an in-depth understanding of value investing and how it works. Here, we look at the concepts behind value investing as well as approaches to reduce your investment risks and maximize returns.
As a value investor, you operate under the assumption that the stock market can over- or undervalue assets. Determining the intrinsic or true value of stock requires extensive research, which means you can’t follow the herd or invest according to trends.
Being successful with value investing requires confidence, patience, and diligence. You also need a thorough understanding of the stock market and various valuation metrics to determine a stock’s intrinsic value.
Invest for the long run
With value investing, the objective is to generate low-risk, consistent returns. Don’t allow greed or fear to affect your long-term investing philosophy.
You should also only invest in companies you understand. Knowing that a company will have a stable output of predictable products for the next 15 years is critical to successful long-term value investing.
Value investing and the efficient market hypothesis
According to the efficient market hypothesis, a stock’s market price always reflects the underlying value of a company. Advocates of the efficient market hypothesis argue that the stock market is a weighing machine – for every bullish buyer, there is a bearish seller.
If you believe the efficient market hypothesis, you believe that the share price of a stock and its true value are always the same. In other words, stocks never trade at bargain prices.
However, the efficient market hypothesis assumes that every investor is rational, while this is not the case. For example, during the dot-com bubble, investors became overexcited about an experimental technology, and stocks became overpriced. Likewise, a poorly performing economy or bad news can induce panic among investors, and the sell-off can result in underpriced stocks.
Value investors don’t believe in the efficient market hypothesis. According to Warren Buffet, the market is inefficient, and value investors can successfully exploit share prices trading below their true value. Below, we look at the factors that can drive stock trading prices down.
Why do stocks trade below their intrinsic value?
Ignoring the efficient market hypothesis allows value investors to determine why stocks become undervalued. Below, we look at several reasons for stocks to trade below their intrinsic value.
Some businesses are sensitive to environmental and economic fluctuations. Factors affecting companies’ profits include the economy’s performance and consumer spending patterns. For example, a company selling camping gear will experience lower sales and profits during the winter months.
Low profit levels affect the trading price of a company’s stock. However, a temporary decrease in profits doesn’t determine the company’s value over the long-run. When a company experiences a cycle of low profits, the market may undervalue its stock.
Herd mentality is an investment phenomenon in which investors base their investment decisions on the market movements instead of their own analyses. When a company’s stock price starts increasing, investors fear missing out, and they start buying, which accelerates the upward movement.
The same thing happens when a stock price, or the market itself, starts declining. Investors who follow the market movements start selling out of fear that the market will never change direction. Such a large sell-off amplifies the downturn in the market, resulting in an undervaluation of the stock.
Investment bubbles and market crashes
An investment bubble happens when herd instinct and overinvestment drive stock prices to unsustainably high levels. During a prolonged bull market, stock prices can rise above companies’ real worth in terms of earnings. As stock prices become unsustainable, investors start panicking, and a sell-off ensues, which causes a market crash.
A crash can cause a stock’s trading price to fall far below its intrinsic value. History teaches that a rising market rally will follow a crash to correct the market, which means that a crash may hold the opportunity to find high-value stocks on the cheap.
Boring or overlooked stocks
Most prospective investors want to invest in trendy stocks, such as Google, Facebook, and Apple. However, these stocks are highly susceptible to herd instinct investing.
To find profitable high-value stocks, consider the unglamorous but established companies with high expected earnings and growth. You should also analyze foreign and small-cap stocks, as they typically don’t get news coverage and are often undervalued.
When a company releases bad news, investors tend to overreact and sell off their shares, causing the share price to plummet. When these knee-jerk reactions of investors are unfounded, opportunity lurks for the value investor.
Examples of events that can cause a stock undervaluation include:
- Announcement of financial results that don’t meet expectations
- Announcement of litigation against a company
- Whistleblowers reporting company engagement in unethical or fraudulent practices
- Questions by the Securities and Exchange Commission (SEC) about a company’s financial reports
- Failure by a company to meet industrial regulations
- Public relations crises, even if the company is not at fault
Over the long run, bad headlines are often insignificant, and you can expect an established, growing company to retain its value.
Evaluating value stocks
How to find a company’s intrinsic value
Intrinsic value is the calculated or real value of a stock, currency, or company and may or may not be the same as the asset’s market price. No universal standard for calculating stocks’ intrinsic value exists, and this value can be challenging to calculate.
Intrinsic value is also subjective. Some investors may base the value on qualitative factors, such as market factors and the company’s business model. Others will use quantitative factors, such as a company’s earnings potential.
As a value investor, it’s up to you to determine a stock’s intrinsic value through fundamental analysis, which examines various financial factors, including the company’s:
- Financial performance
- Cash flow
Fundamental factors to study include the company’s:
- Business model
- Competitive advantage in the market
- Target market
Margin of safety
This financial metric is the discounted market value of a stock as a percentage of its intrinsic value. As a value investor, you should set a margin of safety that matches your unique risk tolerance.
For example, Benjamin Graham, the father of value investing, only bought stocks if their trading prices were 67% of the intrinsic value or lower. Warren Buffet believes the margin of safety to be the cornerstone of investing and often sets his price target at 50% of the intrinsic value.
With value investing, you have to rely on your own information and common sense, which is why thorough research is of the utmost importance. According to Christopher H. Browne, author of “The Little Book of Value Investing,” you should ask if a company is likely to increase its revenue with the following methods:
- Increasing product prices
- Increasing sales volumes
- Decreasing expenses
- Closing or selling unprofitable segments
Answering these questions can be a challenge, as there is no way to predict the future. At best, you can make an educated guess. However, if you only invest in familiar industries, which Warren Buffet recommends, it becomes easier to gauge a company’s future growth.
Below, we look at ways to gather information to evaluate a company’s future growth and determine if a stock is a viable option for value investing.
A company’s top-level management, directors, and shareholders who own 10% or more of the company’s stock have in-depth knowledge about its performance. If owner-managers are buying stock, they see potential profit growth, and you can consider the stock as a value investment.
A stock sale by an owner-manager doesn’t necessarily indicate a problem. However, in the event of a mass sell-off by owner-managers, further fundamental analysis is necessary to determine the stock’s intrinsic value.
Examine financial statements
When researching a company’s growth prospects, you should analyze its financial statements to evaluate future growth prospects. The assets, liabilities, and shareholder equity listed in a company’s balance sheet define its financial position.
Using stock metrics helps identify undervalued stocks in the market and plays an integral role in fundamental analysis. Stock metrics are financial ratios, and they give the value investor key insights into a company’s financial performance and earning potential. These are a few of the most commonly-used metrics for valuing a company.
Price-to-earnings (P/E) ratio
The P/E ratio divides a stock’s current price by its earnings per share and shows the price the market is willing to pay for every dollar the company earns. A low P/E value indicates that the stock costs less per share for the same financial performance level than a stock with a relatively high P/E value.
Generally speaking, a P/E ratio below 15 indicates a cheap stock, while expensive stocks have a P/E value of 18 or higher. It is not uncommon for growth stocks to have P/E values of more than 70.
Price-to-book ratio (P/B) ratio
The P/B ratio divides the stock’s share price by the company’s net assets minus intangibles, and it measures a stock’s valuation by comparing a company’s market capitalization to its book value per share.
Debt-to-equity (D/E) ratio
The D/E ratio is a financial leverage ratio comparing a company’s liabilities to its shareholder equity. D/E values vary by industry, but stocks with a D/E ratio of 2.0 or more are not viable options for value investors. A D/E ratio of 2.0 indicates that the company’s capital financing consists of two debt units for every equity unit.
Free cash flow (FCF)
FCF is the cash a company produces through its operations minus operating and capital expenditures. In other words, free cash flow indicates a company’s ability to generate cash. The higher a company’s FCF, the better its ability to fund operations and pay dividends.
If a company has a high FCF value but a low share price, it may indicate an undervaluation by the market.
The current ratio divides total current assets by total current liabilities and indicates a company’s ability to meet its short-term obligations. A prospective investor should research to determine the optimal current ratio for the particular industry. When evaluating a company’s current ratio value, consider the values of past years as well.
The book value equals total assets minus total liabilities and is the company’s shareholder equity. The book value consists of shareholder contributions and retained earnings the company didn’t pay out as dividends.
Review of financial reports
Four times a year, companies have to report their financial earnings via a Form 10-Q. Value investors can use a company’s financial reports to determine if they should buy, sell, or avoid its stock.
Quarterly financial reports contain the following:
- Revenues and expenses
- Profit or net income for the quarter
- Earnings per share
- Beaten or missed estimates
- Guidance estimates according to the company
A 10-Q form includes a press release from the company giving an overview of its earnings. Most investors review the press release to save time. Some financial reports include a management discussion section providing valuable information about various aspects relating to the company.
What are the risks of value investing?
Value investing is a low-to-medium-risk strategy. However, like all investment strategies, value investing has inherent risks. Being aware of the risks will allow you to manage them and ensure a successful investment.
Value investors have to rely on their own fundamental analyses to determine the intrinsic value of stocks. If the financial information you use in your analysis is not up-to-date or is inaccurate, you will either invest in the wrong stock or miss out on a profitable investment.
An in-depth understanding of fundamental analysis, valuation metrics, and financial statements is also critical. If you can’t analyze financial statements with confidence, spend some time to improve your knowledge and skills. You can also read the financial statement notes for more information on the report or a particular company’s accounting methods.
Dealing with extraordinary items
A company’s income statement may reflect extraordinary items that are unusual or infrequent. An extraordinary item doesn’t form part of a company’s day-to-day activities, but it significantly impacts its financial performance.
If you encounter an extraordinary loss such as a natural disaster or lawsuit, you should exclude it from your analysis to determine the company’s potential for future growth accurately. However, you may have to include non-recurring items such as losses or gains from the sale of an asset or the losses of shutting down a business division.
Buying at high trading prices
The objective of value investing is to buy an undervalued stock and wait until the trading price catches up with the stock’s intrinsic value. If you buy a stock at a trading price that’s too high, you’re leaving money on the table.
Establishing a margin of safety is the most effective way to mitigate this risk. A margin of around 67% is generally sufficient to ensure that you’re not overpaying for a stock. If you have a low risk tolerance, consider lowering your margin of safety.
Ratio analysis limitations
Ratios are useful tools for determining the financial performance of a company. However, ratio analysis limitations may result in misleading conclusions about a stock’s intrinsic value. The critical ratio analysis limitations include:
- Incomparable numbers across different periods due to inflation
- Changes in a company’s accounting procedures and policies
- Incomparable financial metrics due to operational changes
- Seasonal effects can lead to false interpretations
- Financial statement manipulation by the company
Reading the financial statement notes and additional sections can help to avoid these risks. In some cases, companies may include the formulas they used to calculate their ratios.
Lacking patience or confidence
With value investing, one of the biggest challenges is being confident in your investment philosophy. After using your savings to purchase a stock, it can be easy to convince yourself that the herd knows something you don’t. While a downward trend can also be panic-inducing, you mustn’t listen to your emotions.
Value investing is a long-term strategy. The trading price of a stock can take months or years before it reaches its intrinsic value. With sound fundamental analysis and a margin of safety, it will be easier to leave your emotions out of the equation.
Lacking portfolio diversification
Everybody knows that putting all your eggs into one basket is a risky strategy. Exposure to several economic sectors is a safeguard against an extended bear market. According to Christopher H. Browne, proper diversification requires at least ten stocks in different industries.
However, not all value investors agree that diversification is an effective strategy for high returns. According to Warren Buffet, diversification doesn’t make sense if investors know what they are doing. Diversification can also prevent you from investing in industries you understand.
Whether or not you should diversify depends on your background and investment philosophy.
How does value investing differ from growth investing?
A growth stock is a security with an expected growth rate higher than the average market growth rate.
With growth investing, you can realize high returns within a relatively short period. If a growth stock’s dividend payouts grow in tandem with its earnings, you can also generate a sizable income stream from your investment.
The downside of growth investing is that market downturns have a significant impact on growth stocks. With growth investing, you also can’t set a margin of safety, which increases your risk.
As a value investor, you are looking for the ultimate bargain, which are high-value stocks that are temporarily out of favor with investors. Unlike growth investing, value investing is a low-risk strategy, and you ignore investment trends and fads that can cloud your judgment. The most significant drawback of value investing is a relatively low return per year.
Growth stocks such as Alphabet (Google) and Amazon outperformed value stocks for the past decade. However, value stocks have been trading at increasingly lower prices relative to intrinsic value since March 2020. With top forecasters predicting bear market waves up to 2023, investors can now take advantage of value stocks selling at steep discounts.
When it comes to building wealth, value investing is one of the most effective strategies. If you are an investor who can remain invested with your stocks without succumbing to panic, value investing holds the opportunity for reliable wealth creation over the long run.
Investors who are new to value investing should spend the time and resources to learn fundamental analysis and familiarize themselves with the inherent risks of this strategy. Formulating and implementing a sound value investment strategy is also integral to value investment success.