Value Investing Definition
Value investing is a long-term strategy that involves buying and holding undervalued securities, real estate, or other financial assets. However, it is more prevalent in the stock market, where investors buy equities that trade below their intrinsic, inherent, or book value. Any future gain in value generates profits for investors.
This investment strategy requires buyers to conduct a comprehensive fundamental analysis of a company to determine its underlying value. Value investing entails analyzing financial statements and other metrics like P/E, P/B, PEG, D/E ratio, etc. Investing in underpriced stocks allows traders to build wealthWealthWealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation. from the price increase in the long run.
Table of contents
- Value Investing Definition
- How Does Value Investing Work?
- Value Investing Strategies
- Value Investing Metrics
- Frequently Asked Questions (FAQs)
- Recommended Articles
- Value investing is a long-term investment strategy that entails purchasing and keeping discounted shares, bonds, real estate, and other financial assets. Investors profit from any future increase in value.
- The market undervalues a stock due to panic trading, the poor state of the economy, struggling corporate performance, not-so-good business news, market crashes, and cyclicality.
- Investors perform a comprehensive analysis of the company that includes analyzing financial statements, balance sheets, P/E, P/B, PEG, and D/E ratio to assess its underlying value.
- Value investing is not the same as growth investing, which is buying stocks that have a chance of outperforming the market.
How Does Value Investing Work?
Value investing strategy enables investors to buy stocks at discounted prices for the long-term and benefit from the market overreaction. These are the securities that are likely to be valued at a high price. Value investing differs from growth investingGrowth InvestingGrowth Investing refers to capital allocation in potentially high earning companies such as small caps and startups, which grow much faster than the overall industry or mature companies. Because the returns on such investments are high, the risk that such investors face is also higher., in which investors invest in stocks with the potential of giving higher-than-average returns. The concept was first proposed by two American economists, Benjamin Graham and David Dodd, in 1928.
The market underestimates and overestimates an asset, depending on trading volume, economic condition, company performance, business news, etc. Other factors that can affect the stock performance include market crashesMarket CrashesA stock market crash occurs when stock prices in all sectors begin to fall rapidly. It is often the result of global factors such as war, scam, or the collapse of a certain industry. In such a crash, panic acts as a catalyst., cyclicality, and unpopularity. Investors keep a tab on these activities and invest in stocks on sale in the hopes of selling them at a higher price than their intrinsic valueIntrinsic ValueIntrinsic value is defined as the net present value of all future free cash flows to equity (FCFE) generated by a company over the course of its existence. It reflects the true value of the company that underlies the stock, i.e. the amount of money that might be received if the company and all of its assets were sold today.. In doing so, they follow the margin of safety principle to minimize the loss if the stock price declines post-purchase.
Margin of Safety = Intrinsic value – Current value
Assessing the intrinsic value of an asset necessitates an in-depth financial analysisFinancial AnalysisFinancial analysis is an analysis of finance-related projects/activities, company's financial statements (balance sheet, income statement, and notes to accounts) or financial ratios to evaluate the company's results, performance, and trends, which is useful for making significant decisions such as investment, project planning and financing activities. of the company, including its revenue, brand value, business model, competitive edge, etc. Also, value investing considers the company’s position in the books, records, financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels., and balance sheetsBalance SheetsA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.. Despite having an excellent track record, some companies are undervalued in the market, presenting an investment opportunity before they reach or exceed their actual value. Hence, investors use value investing metrics to determine whether purchasing their stocks is worthwhile.
Value Investing Strategies
Investors need to adopt a well-thought-out strategy to get the most out of value investing stocks, such as:
- Researching the company history and reputation
- Analyzing its products and services and competitors
- Evaluating its growth strategies and prospects
- Looking into its balance sheet, i.e., assets, liabilities, and equityEquityEquity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet.
- Studying its financial statements for operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit. and business profits
- Examining its credit rating and involvement in any financial scams
- Investigating insider tradingInsider TradingInsider trading is defined as the act of taking key trading decisions related to a company’s listed stock using critical non-public information. The US Securities and Exchange Commission (SEC) penalizes offenders of illegal insider trading as it causes material loss to the investors. It also shakes their faith in the stock market. by company officials
Value Investing Metrics
Value investors utilize different metrics to perform value investing, including:
#1 – Free Cash Flow
It determines the amount of cash available after paying operating minus capital expenses for the company administration, operation, and upkeep. It also aids in the payment of dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity., interest, and creditor debts.
Free Cash Flow = Cash for Operations – Capital Expenditures
#2 – Price-to-Earnings (P/E) Ratio
PE RatioPE RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. is the proportion of the market price of a company’s share to its annual earnings per share. In most cases, a smaller ratio indicates that the stock is cheap or value stock, and vice versa.
P/E Ratio = Market value per share / Annual earnings per share
#3 – Price-to-Earnings-to-Growth (PEG) Ratio
It is an enhancement to the P/E ratio since it considers the company’s unanticipated growth returns. The PEG ratioPEG RatioThe PEG ratio compares the P/E ratio of a company to its expected rate of growth. A PEG ratio of 1.0 or lower, on average, indicates that a stock is undervalued. A PEG ratio greater than 1.0 indicates that a stock is overvalued. is often considered one of the most accurate indications of a stock’s underlying value.
PEG Ratio = P/E ratio / EPS Growth
Here, EPS denotes earnings per share = (Net Income – Preferred Dividends) / Average Common Shares
#4 – Price-to-Book (P/B) Ratio
Price to Book ValuePrice To Book ValuePrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share compares the market value of a company’s assets in the financial statements and book with its stock price. If the share price remains lower than the book value or below 1, it signifies the undervalued stock.
P/B Ratio = Market price per share / Book value
Here, Book Value = Company’s net worth (assets – liabilities) / Total outstanding shares
#5 – Debt-to-Equity (D/E) Ratio
Debt to Equity RatioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. gauges the financial stability of a company based on its current liabilities and shareholder equity. Calculating a company’s assets backed by debts is difficult as they vary from one industry to another.
D/E Ratio = Company’s total liabilities / Shareholder equity
Let us look at the following examples to understand the value investing strategy better:
Richard, who has only recently begun investing, is unfamiliar with stock exchanges and financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.. To diversify his portfolio, he invested some of his money in blue-chip and midcap stocks. He wishes to invest a significant amount of money in equity for a long time, making value investing rather than direct investments.
A new food service company launches its initial public offeringInitial Public OfferingAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange. (IPO) on the stock market at a lower price. It sparks speculationSpeculationA speculator is an individual or financial institution that places short-term bets on securities based on speculations. For example, rather than focusing on the long-term growth prospects of a particular company, they would take calculated risks on a stock with the potential of yielding a higher return. that the firm will underperform in the stock market. Richard, on the other hand, has a different opinion. So he starts researching the company, examines its records, balance sheet, financial statements, and prospects based on various value investing metrics.
The fundamental analysisFundamental AnalysisFundamental Analysis (FA) refers to the process of studying any security's intrinsic value with the object of making profits while trading in it. The primary purpose of fundamental analysis is to determine whether the security or stock is undervalued or overvalued and thereby make an informed decision to buy, hold, or sell it in order to maximize the potential for gains. concludes that the company stock is undervalued. However, it has tremendous potential for high market returns. So Richard invests a significant sum of money in the company’s stock, and five years later, he earns far more than he anticipated.
In the first quarter of 2021, value stocks in the United States grew dramatically, supported by the resurgence in technology equities. It happened due to investors buying shares in companies in the hopes of prices going up post the COVID-19-affected U.S. economy. However, the growth was akin to the financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors. of November 2008, as it remained 11% below their historical average market discount.
These stocks traded 74% cheaper than growth equities, as measured by the Russell 1000 value index. Besides, Credit Suisse predicts corporate earnings to expand by 26.4% in 2021, while the Federal Reserve forecasts the U.S. economy to grow at 6.5%.
Frequently Asked Questions (FAQs)
Value investing is a method in which investors seek out undervalued stocks trading at a discount than their inherent value. Panic trading, the terrible economic condition, faltering company performance, market crashes, and cyclicality can cause the market to undervalue a stock. Investing in these undervalued stocks provides investors with a fantastic opportunity to invest and earn and accumulate wealth over time as the price rises.
Investors often follow a well-considered strategy to get the most out of value investing stocks. It requires researching the company, analyzing its rivals, evaluating its growth prospects, looking into its balance sheet and financial statements, checking its credit rating, and inquiring into insider trading.
While both approaches can help investors get the most out of their investments, one has a distinct advantage over the other. Value investing strategy allows investors to acquire and hold stocks trading at less than their actual value. But in growth investing, investors seek securities that have above-average potential for revenues and earnings growth.
This has been a guide to value investing and its meaning. Here we discuss how does value investing works along with strategies, metrics, and examples. You may learn more about financing from the following articles –
- Passive InvestingPassive InvestingPassive investing is a strategy used by investors to maximize their returns by avoiding frequent portfolio churning by buying and selling securities and instead buying and holding a diverse range of securities.
- Ethical InvestingEthical InvestingEthical investing is a type of investing process where investors consider morals, values, religious, political and social environment before making investment decisions. It has both positive and negative effects in general.
- Investing in CurrencyInvesting In CurrencyInvesting in currency means purchasing one currency while selling the other pair or leg. This is accomplished through the Foreign Exchange market, also known as Forex. Spot trading, forward trading, and future trading are the top three ways to invest in currency.