What Is Value Investing?
Value investing is a method where the investor selects stocks that have a market value lower than their intrinsic value. Such stocks are assumed to be underpriced and the investor holds them until they reach or exceed their true price. This method is done on the premise that undervalued stocks will appreciate their value over time and yield profits for the investors who hold them long enough.
Investors opting for this method of investing search for companies with strong fundamentals by analysing their cash flow, earnings stability as well as debt ratios. Apart from the statistics, the investors also consider other factors such as industry trends, competitive advantages and disadvantages, and management strategies. This method requires patience as well as strong analytical skills.
How Does Value Investing Work?
Value investors believe that short-term market fluctuations can result in the share prices deviating from their intrinsic value. They begin their search for potential stocks by analysing the company’s fundamentals and filtering the stocks that might be trading for a price below their worth.
After purchasing the chosen shares, the investors hold on to the stocks believing that the market will eventually realise their true worth, resulting in capital appreciation. The investors chose the share by keeping a margin of safety – the difference between the intrinsic value and the stock’s market price. The value of the safety margin depends upon the investor’s risk tolerance.
How Do Investors Derive Intrinsic Value?
The investors carry out fundamental analysis of the companies of their chosen stocks. These stocks are believed to be undervalued, so verifying them before investing is important. Hence, the investors conduct thorough financial analysis and stock valuation using various metrics. Some of the useful metrics for evaluating a company’s stocks are as follows:
- Price-to-Book (P/B) or Book Value
The difference between a company’s total assets and liabilities is its book value. This ratio helps to understand the worth of a company in terms of its books of accounts. This ratio can be calculated by dividing the latest closing share price of the company by its most recent available book value per share.
- Price-to-Earnings Ratio (P/E) or Earnings Multiple
It is calculated by dividing the current share price by earnings per share (EPS). This metric denotes the amount that each investor pays for each buck of a company’s reported profit. This metric is very useful to determine if the stock is undervalued or overvalued.
- Free Cash Flow
Free cash flow is calculated by subtracting the capital expenditures from the cash from operations. This value denotes the funds available to the shareholders after deducting the expenses and investments.
- EBITDA – Earnings Before Interest, Tax, Depreciation and Amortisation
It is a different way of calculating the profitability of a company. Including the amounts of interest, tax, depreciation and amortisation depicts how much a company is profiting from its core business activities. This parameter can be preferred over EBIT for asset-intensive companies.
- EBIT – Earnings Before Interest and Tax
EBIT can help an investor understand the business’s cash flow pertaining to the core business activities as it removes secondary expenses and profits from the equation. EBIT is also called operating income.
While assessing the stock of a company, it is important to consider various factors such as equity, debt, revenue growth, earnings per share, etc. Apart from the ratios and technical aspects, other qualitative factors include industry, corporate governance, business model, etc.
Once the investor carries out the analysis, they can estimate if the stocks are undervalued and carry the required margin of safety. Based on these parameters, they decide whether to purchase the stock.
Advantages of Value Investing
- Higher Returns
Undervalued stocks contain the potential to outperform the market when the market recognises their true worth. This can result in a significant capital appreciation for the investors and the stocks may even outperform the market. Moreover, higher returns can also provide a hedge against rising inflation.
- Reduced Volatility
The investor’s in-depth analysis helps them reduce uncertainty about the stock’s valuation and make data-driven decisions. In addition, trading with the margin of safety can also reduce the risk of losses even if the market takes longer than anticipated to recognise the stock’s true value.
- Suitable for Long-Term
Undervalued stocks take time to appreciate in their value depending on the market conditions and other factors. However, investing in them for a long time can ensure growth over a longer tenure.
- Reduced Transaction Costs
Value investing focuses more on holding the stocks rather than a continuous cycle of buying and selling. The frequent transactions can result in higher costs due to a levy of fees like commission or brokerage.
- Passive Income
Apart from capital appreciation, value investors can also opt for the undervalued stocks that yield regular returns in the form of dividends. It is a common strategy used in value investing and can help create a passive income while the stocks appreciate.
Disadvantages of Value Investing
While value investing can be attractive for investors, it is also important to consider the potential cons attached to it. Following are some of the disadvantages to consider before investing:
- Market Knowledge Required: To carry out the fundamental analysis of a company and the stocks, the investor needs to have a strong hold on analytical skills, in-depth research skills, and the ability to identify the undervalued company stocks.
- Rigidity: The value investing approach depends on the underappreciated stocks. Such stocks may belong to a specific industry or trend currently out of alignment with the market. This provides less opportunity for diversification and makes this method a more rigid approach to investing.
- Patience Requirement: This investing method might seem patience demanding for the investors. A market might not recognise the true value of a stock immediately. Underperformance of a stock for an extended period of time can be frustrating for the investor.
Strategies for Value Investing
- In-depth research and analysis: Analysis is one of the most prominent aspects of value investing. Before making a decision, dive deeper into the fundamentals of the company. Go through the company’s financial statements, industry characteristics, future growth potential, competitive landscape etc. Being well-informed about the company’s fundamentals can help deduce a stock’s true worth.
- Clear objectives: Setting clear objectives can help make selecting stocks effortless. It may include listing down the criteria of the stocks that are to be selected. Moreover, setting a goal for profit can also determine the exit point of the selected stocks.
- Margin of safety: Creating a threshold for the difference between market value and the intrinsic value of stocks is crucial to safeguard your investment. Investors can aim to buy stocks with a higher safety margin, thereby protecting them from short-term market fluctuations.
- Disciplined approach: Value investing can be time-consuming as the selected stocks’ capital appreciation may take longer than anticipated. To tackle this, the investor must not make any hasty decision and continue to hold the investment with patience and discipline.
- Monitor portfolio performance: Be on the lookout for market fluctuations, price changes of the invested stocks as well as news about the company and the industry. This can help the investor identify the trajectory of the stock prices and decide if any event causes a permanent decline in the price of the chosen stock.
- Professional advisor: Checking your facts from a professional can help your decision-making process regarding value investing. Professionals can provide valuable advice to investors, especially those unfamiliar with the stock market.
Difference Between Value Investing and Growth Investing
| Feature | Value Investing | Growth Investing |
| Meaning | Investing in undervalued stocks based on their company’s fundamental analysis | Investing in companies that have the potential for growth in the future, regardless of the current market share price. |
| Risk tolerance | Comparatively low, seeks stability | Comparatively high, seeks growth |
| Trading price | Traded at a discounted price | May be traded at a high price |
| Dividend payouts | May receive dividends | Typically, they don’t receive dividends as profits are reinvested for growth |
| Investor mindset | Disciplined | Opportunistic |
FAQs
How to start value investing?
Analyse the fundamentals of the company. Starting with small amounts can reduce the risk. One may increase investment amount once they gain confidence.
Is value investing better than trading?
Value investing can be better for investors with lower risk appetite, preference for stability or are looking to invest for the long term.
What is an example of value investing?
Value investing can be compared to purchasing a commodity on sale. In a sale, you purchase a commodity for less than its worth. In value investing, you purchase stocks listed at a price lower than its actual worth.
