Last Updated on Sep 21, 2022 by Aradhana Gotur
The ‘father of value investing’, Benjamin Graham, popularised an investment paradigm in the 1920s. He called it ‘value investing’. Business tycoons and investors like Warren Buffett and Seth Klarman also follow this technique for their investments.
The concept is based on a stock’s valuation – whether it is overvalued or undervalued.
Table of Contents
What is value investing?
Value investing means investing in undervalued stocks that have a high potential but often go unnoticed. The investments in such shares, which are called value stocks, are usually done for the long term.
What is value investing strategy?
Value investing refers to a strategy followed by investors to pick undervalued stocks in the market. Investors do elaborate research and use their expertise to find these undervalued stocks. Long-term investing is another basic tenant of the value investing strategy.
How does value investing work?
The efficient market hypothesis states that the markets have perfect information and determine the equilibrium value of shares. But, stock markets are inherently volatile and prone to fluctuations. As such, stock prices constantly change due to many uncontrollable factors.
Therefore, the price at which a stock is trading on a stock exchange may not be justified, or in other words, it may not be the fair price. This means the stock is trading at a value lower than the intrinsic value. So it could be undervalued (trading at a discount) or overvalued (trading at a premium). Value investing looks to profit from the market’s ignorance and invest in undervalued stocks for the long term.
A stock could be undervalued for various reasons – a bad quarterly performance, sudden adverse news for the company or poor economic situations. So even if the factors are out of the company’s control, the stock may suffer, resulting in shareholders liquidating their holdings. This then becomes an opportunity for value investors to invest in such stocks. Because value investors focus on the quality/fundamentals of stocks no matter the prevailing situation.
How to find value stocks?
The key to finding value stocks (those trading lower than their intrinsic value) is doing a thorough fundamental analysis of a stock. You can start by doing an industrial analysis, studying the company’s financial statements, evaluating the management and key personnel, finding the company’s growth potential, and doing a peer analysis. You can also research how a company has fared in the past. Here are two articles that can help you:
For a quick understanding, here is how you can use various tools to determine the intrinsic value of shares:
- PE ratio
The price-to-earning ratios or PE ratio determines the relationship between the share price of the company and the earnings per share. It is calculated as:
PE ratio = (Current share price / Earnings per share)
It depicts how much money you would have to put in to earn a return of Re. 1 on the share. For instance, assume the market price of the share to be Rs. 50. The EPS for the share is Rs. 15. So the PE ratio will come out to be 3.33. This implies that you have to invest Rs. 3.33 to earn a return of Re. 1 from the company.
The PE ratio has an inverse relationship with Earnings Per Share (EPS). A decrease in EPS increases the PE ratio. This increases the amount of investment required to earn a unit of return. A higher ratio may signify that the share may be overvalued.
- PB ratio
The price-to-book value ratio or PB ratio compares the share price to its book value. It is determined as:
PB ratio = (Market value of the share / Book value of the share)
If the market value of the shares is lower than their book value, it indicates undervaluation. If the market price is higher, the stock could be considered overvalued.
- Cash flows
Cash flows are the inflows that are earned on the share over the life of the investment. These can be the dividend and sale price of the stock. You need to discount these cash flows to get an estimate of their present value. Compare the total present value of all cash inflows with the initial outflow, which is the purchase price. This helps in analysing whether the market price is justified.
In addition to the above, you can use many other metrics used in the analysis, including debt, equity, and revenue.
Margin of safety
Since value investing is based on estimations, an investor should make room for error. Value investors set their own “margin of safety” based on risk tolerance. The margin of safety is based on the idea that buying stocks at prices less than their intrinsic value gives a higher chance of earning a profit on selling them. Similarly, the margin of safety also helps investors minimise their losses if the stock doesn’t perform well. Here’s an example:
If the intrinsic value of a stock is Rs. 100, you can consider a margin of safety of 20%. So you can adjust it for Rs. 80. If you buy it for Rs. 50, you can earn a profit of Rs. 30 by waiting for the price to reach its adjusted fair value of Rs. 80. If the company grows further, you get a chance to make more money. Say that the stock price increases to Rs. 100. In that case, you will make Rs. 50 as profit. And if it grows more, you make even more. This is only possible because you bought it at a discounted price.
Features of a good value stock
- It has an inexpensive valuation compared to its fair value
- It is of a well-established company that have histories of being successful
- Such a company has made consistent profits
- The company has stable revenue streams
- The company pays dividends – this is not a mandatory qualification
Note that these are only indications of a good value stock. Sometimes, a stock may have all these features but still not qualify as a value stock. It would be a value trap.
Why invest in value stocks?
Value stocks are available at discounted prices to their intrinsic values, thus increasing the chance of earning profits. If this is appealing, you can consider value investing. Further, if you are more of a conservative investor that doesn’t have a high tolerance for risk, adding a good value stock to your portfolio and holding it for long can help you grow your wealth.
Things to keep in mind when picking value stocks
- Determining the intrinsic value of a stock is both a science and an art. It involves a deep analysis of the underlying company’s financial statement. It requires good judgement.
- When you buy a stock, you get a percentage of ownership in the company. So ensure that the company’s fundamentals are strong. Besides fundamentals, value investors also deeply care about a stock’s intrinsic value.
- Valuation is subjective — what may be a fair value of a stock to you may not be for another and vice versa. That means each investor values stock differently.
- Regardless of the depth of the analysis, the fact remains that the valuation of shares is an estimation. There is always room for error, and value investors should leave a margin for it. This helps mitigate risk.
- As per the efficient market hypothesis, stock prices account for all information about a company, which means its price always reflects its value. But value investors believe that the markets are not efficient. And so, the stock price may be undervalued or overvalued based on many factors.
- Do not follow the herd. Generally, value investors are contrarians. When everyone else is buying a stock, they hold or sell it, and when everyone else is selling it, they buy or hold it.
- As per value investors’ strategy, trendy stocks are typically overpriced and so value investors don’t buy them. Instead, they analyse the financials of unpopular stocks and invest if the prospects look strong.
- You can also keep a watch on fundamentally strong stocks that have declined in recent times. Since their fundamentals are strong, such stocks can recover from setbacks.
- While some value investors only look at existing financials, others focus primarily on a company’s growth potential and estimated cash flows. It is best to consider both when identifying mispriced stocks.
- Value investing advocates a long-term investment horizon and doesn’t provide instant gratification. It makes sense to wait a few years to reap the optimal returns on a stock.
Why do stocks become undervalued or lose value?
- Some investors ignore fundamentals and logic and base their investments on psychological biases. When the market at large or a specific stock is rallying, they buy. They are driven by the fear of missing out – had they invested a few weeks ago, they could have earned a certain profit by now. In contrast, when the overall market or a stock price is falling, investors sell driven by loss aversion. Such psychological biases influence the value of the stocks.
- When the overall market soars at unsustainable levels, it typically crashes. This panics investors, who exit the market resulting in a massive selloff. As a result, individual stocks lose value.
- As mentioned earlier, not all trending stocks are priced fairly. Going by that, a few unpopular stocks like small caps and foreign shares may not be on investors’ watchlist and may be undervalued.
- Bad news tends to drag down the value of a stock. Even good companies go through bad times. However, it doesn’t mean that a company is not fundamentally strong. If the company takes corrective measures to address what’s causing issues, it can recover.
- The stock market cannot be predicted. Analysts’ expectations relating to a company’s earnings and forecasts as mere estimates, not guarantees. However, investors panic when a company is unable to beat analysts’ expectations and exit its holdings, bringing down the stock prices.
- Some companies are cyclical in nature. They may be at the mercy of seasons, economic cycles, consumer attitudes, and other factors. This can impact the company’s profit and stock price.
Value investing strategies
- Since value investing involves a lot of guessing and speculation, Warren Buffett suggests investing only in industries you have worked in or whose goods you are familiar with, including clothes, cars, and food.
- A famed value investor, Christopher H. Browne (director at Tweedy, Browne), advocated finding out if a company is likely to increase its revenue by raising product prices, increasing sales, reducing expenses, and shutting down unprofitable divisions. Browne also suggested analysing a company’s competitors to ascertain its growth prospects. Again, the answers to these questions are mostly speculative and have no numerical data to support them. So use your best judgement to get the answers.
- Some value investors invest in stocks of companies that sell products that have a high demand. Also, find out how long these companies have been in the market and how they have dealt with challenges in the past.
- Gauge the outlook of the insiders of the company. Insiders are the company’s promoters, directors, senior managers, and shareholders who own at least 10% of the capital. If you see them purchasing the stock, the company probably has good prospects, and that is why they may be betting on it. Conversely, if there are mass sell-offs by insiders, one of the reasons, though not always, is a sign of caution. However, it is best to do further in-depth analysis to find the reason. You can use Stock Deals to analyse what key personnel of a company think about it.
- A company’s annual report offers a treasure trove of qualitative and quantitative information. In it, you can learn about the company’s products and services, management, corporate governance, past and recent financial performance, and so on. You can get the Annual Reports in the Financial tab of Tickertape’s Stock Page.
- Look at the company’s financials to get cues. Analyse the company’s financial statements like the income statement, balance sheet, and cash flow. While the income statement talks about the company’s profitability, the balance sheet throws light on the company’s assets, liabilities, and share capital. The cash flow suggests the company’s cash position, how much is generated and how much is spent. Guage a company’s past performance using these financial statements and compare it with peers. Do quarter-on-quarter and year-on-year analyses. This will help understand the company’s near-term and long-term growth prospects. You can find the quarterly financial statements in the Financials tab of Tickertape Stock Pages and the annual statements in the annual report.
- Consult financial advisors. If you are not familiar with stock investing, seek professional advice from genuine financial advisors. They have extensive knowledge, experience, and smart tools at their disposal. Make informed-investment decisions through them.
Risks of value investing
In general, stock markets are risky. So as with any investment strategy, value investing also has a risk of loss. With that premise, let’s look at what can increase the risk of loss in value investing.
- Not researching properly. Analysing takes correct information (qualitative and quantitative) about the company, time, and patience. So if you lack in any of these and invest in a stock anyway, you would incur losses.
- A company with a great track record can earn extraordinary income or incur unreal losses in a particular quarter or year. This could be due to various reasons that are one-off instances. For instance, a company’s cash may have depleted to a large extent. This may be because of debt repayment, which is a good thing. Had you not analysed the reason behind a huge cash outflow, you would’ve missed out on this opportunity. In contrast, if extraordinary items are a pattern, it can be a sign of caution. So use your judgement when analysing companies with extraordinary items.
- Relying solely on ratio analysis. The thing about ratio analysis is that using single ratios in isolation can be misleading. You simply shouldn’t gauge a company’s debt and equity proportion and decide whether it is a good buy. You should also look at other ratios that talk about the company’s profitability, ability to generate earnings on your investment, stock valuation, and so on. Only then will you get a bigger picture of the stock. Also, there are no ideal ratios, it all depends on the nature of a company and the sector that it operates in. For instance, a capital-intensive company can have massive debt because it needs significant capital. As a result, it may have a high debt-to-equity ratio. Even so, other ratios may indicate that the company is doing well.
- Buying an overvalued stock. As discussed, calculating the intrinsic value of a stock involves a lot of estimations. So the fair value of a stock is subjective. So if you misjudge the value of a stock and end up overpaying for it, you may incur a loss.
- Not diversifying your portfolio. Individual stocks are highly risky. Therefore, it makes sense to invest in multiple stocks of varied risks to minimise your losses. You can diversify based on market capitalisation and sector.
- Acting based on your emotions. The market is ruled by investor sentiment. When you invest in a stock market, fear and greed naturally come to you. If the stock is doing well, you can get greedy and buy more of it. A possibility is that the stock is overvalued. In contrast, a stock could tumble, and you might sell it out of fear of further losses. But it could just be a correction or influence of an uncontrollable factor like economic tension. So don’t fall prey to emotions and make hurried, uninformed investment decisions or else you may lose your chance of bigger returns.
Value investing vs growth investing
Unlike value investing, growth investing focuses on fast-growing companies. It focuses on stocks that have the prospects of the company’s revenue and net income growing dramatically. Therefore, growth investors don’t care much about the intrinsic value of a stock but invest based on extraordinary business growth or simply prospects.
Value investing with mutual funds
If investing in stocks is very risky for you, you can consider reaping the benefits of value investing through mutual funds. Some mutual fund schemes invest in value stocks and thus give you your desired exposure.
Conclusion
In simple terms, value investing means scanning high potential, undervalued, often ignored stocks and investing in them for the long term. However, value investing involves immaculate analysis and research. The stock value determined is an estimate and may be different for everyone. It requires a lot of faith not just in your calculations but also in the company’s potential.
Always remember – value investing is done for the long term. This means your funds are employed for a longer duration, and the results may not be immediate. But if you stick around for long enough, you could earn stellar returns. By doing your research and not following the crowd, you can explore the wide earning potential this method provides.
Frequently asked questions
What is meant by value investing?
What are common value investing metrics?
What are value stocks?
Who are the two famous value investors?
Buffett is the CEO of Berkshire Hathaway, an American multinational conglomerate holding company. He started with value investing in his early 20s and used the strategy to get massive returns for investors in the 1960s.
Eventually, Buffett shifted his strategy from buying undervalued stocks to high-quality businesses at reasonable values after being influenced by Charlie Munger, Berkshire’s vice chairman and Buffett’s investing partner.
What are the four pillars of value investing?
1. Mr. Market: Imagine that you buy or sell stocks from Mr. Market, who offers stocks at a price based on his mood. When in a good mood, he sells stocks at very high prices and when in a bad mood, he sells them at low prices. So when stocks are available at high prices, you should cash them, and when they are at low prices, you should buy them.
2. Intrinsic value: This is the true value of a company based on its fundamentals. In the short term, stock prices deviate from intrinsic values due to changing market moods. However, in the long term, market prices circle back to intrinsic values. So investors can make a profit by buying at a low price and selling at their intrinsic value.
3. Margin of safety: Since determining the intrinsic value involves estimation, there should be room for errors. The margin of safety offers a cushion by adjusting the forecast. For instance, if your estimated intrinsic value is Rs. 100. You can consider a margin of safety of 20% and adjust the value to Rs. 80. This way, you can ensure that you don’t overpay.
4. Investment horizon: Value investing advocates long-term investing because the stock price has to return to its intrinsic value. Therefore, it picks undervalued stocks that would outperform in the long term, which would reflect in the stock price.
What are some good value investing books?
-Warren Buffett Letters to Shareholders
-The Dhandho Investor by Mohnish Pabrai
-The Intelligent Investor by Benjamin Graham
-The Warren Buffett Way by Robert Hagstrom
-Value Investing and Behavioral Finance by Parag Parikh
-The Little Book That Beats the Market by Joel Greenblatt
-The Little Book of Value Investing by Christopher H. Browne
