Value Investing is a long-term investment strategy that focuses on picking securities such as stocks or bonds currently trading at a price far below their intrinsic or true value.
Value Investors target securities that the market is currently undervaluing. The goal is to buy these securities while they are still cheaper compared to their true value. They hold on to these investments until the price catches up to or goes beyond the securities’ true value.
The idea behind this investment strategy is fairly simple: the best time to buy something is when it is selling at a “discounted” price. This approach can be applied to anything from buying groceries, to real estate, to company shares in the stock market.
How Intrinsic Value Impacts Value Investing
The intrinsic value of a certain asset is simply its true value. It is determined by analyzing the asset’s fundamental characteristics. For instance, to identify a stock’s intrinsic value, one must objectively assess its worth based on how well a company is doing, as opposed to what the market thinks the value is supposed to be.
In stock value investing, certain metrics are employed to determine the company’s underlying value. Key metrics include cash flow, price-to-earnings ratio, and price-to-book ratio. If the company is doing well on these fundamental facets, value investors may recognize it as a “value” investment worthy of adding to their portfolio.
Value Investing and Market Inefficiency
Unlike other investment or trading strategies, value investing does not rely on the efficient-market hypothesis, which states that the price of a certain asset reflects all underlying information regardless of contradicting fundamental characteristics. Value investors, like Warren Buffett, believe that markets are inefficient and asset prices tend to become over-or undervalued.
Value investors rarely “follow the herd” when it comes to picking assets. They avoid being influenced by sudden, volatile price action. When fear has overtaken the market and everyone else is selling, they are often either buying or holding. When optimism is causing a buying frenzy, they are often doing the opposite. Value investors believe that intrinsic value is king, no matter the price a stock is currently trading. They care less about a company’s current stock price and focus more on that company’s underlying financials and principles.
How to Identify Value Stocks
Value stocks are stocks of companies that have sound financials despite trading at a lower price compared to their true value. These stocks usually fly under everyone’s radar even though they generate consistent profits and have a strong cash flow. With value stocks, investment risks tend to stay low as the prices are already cheaper compared to other investments such as growth stocks. If things go wrong, the losses will be minimal.
Value investors make use of these three key metrics to help them in stock picking:
The P/E ratio is a ratio of a company’s share price to its earnings per share (EPS). Its purpose is to determine if a company is over or undervalued. Undervalued stocks, which value investors prefer, have low P/E ratios. If a company, for example, is currently trading at $60 a share and has an EPS of $20, the P/E ratio would 3. This is well below the stock market average of 20-25 which may give a signal that the stock should be bought. When stock picking is based on valuation, one must be careful and should also conduct due diligence on why a particular stock is being undervalued by the market.
Free Cash Flow
Free cash flow (FCF) is a measure of how well a company is performing in the eyes of shareholders or investors. Free cash flow is what is left after operational expenses and capital expenditures have been deducted from cash revenue. The leftover cash is what will be awarded to shareholders in the form of dividends or buybacks. Value investors use this indicator to determine if a company has healthy financials. A health FCF simply means that a cheap, undervalued stock has a strong potential to increase in value in the future.
The P/B ratio shows the difference between a company’s market value and its book value. It can also determine if a stock is over or undervalued as it shows what investors are willing to pay for each dollar of a company’s net value. Value investors look for companies that have share prices below or slightly above the book value. A P/B ratio with a low value especially below 1, indicates a stock is undervalued and may prove attractive to value investors.
These are not the exclusive metrics investors use to gauge if a stock is undervalued. Value investors often combine these along with other metrics such as return on equity, debt-to-equity ratio, and the PEG ratio to accurately determine market undervaluation.
“An investment operation is one which, opon thorough analysis, promises safety of principal and adequate return”Benjamin Graham once said
When it comes to value investing, much like other long-term strategies, patience and keeping emotions in check are important. Many successful investors find this approach especially useful. In fact, the strategy was popularized by none other than Warren Buffett, who is considered the most successful investor in the world. This method has a strict focus on value and value alone.