Value investing.
Value investing is about finding stocks that appear to be priced lower than their true worth. Investors look for undervalued companies, hoping to profit when the market catches on and the stock price rises to reflect its real value.
The value of your investments may go down as well as up. You may not get back all the money that you invest. If you are unsure about the suitability of an investment product or service, you should seek advice from an authorised financial advisor.
Value investing can be a great strategy, but it takes effort and patience. You need to do thorough research and accept that sometimes your investments won't perform as well as you'd hope.
There are risks involved, and success usually requires a solid understanding of the companies you're investing in and sticking to value investing principles.
What is value investing?
Value investing is all about picking stocks that seem undervalued by the market - essentially, trading for less than their intrinsic value. Intrinsic value refers to the true worth of a company based on its fundamentals, like earnings, assets, and potential growth, rather than its current stock price. It is important to remember that value stocks do not necessarily equate to cheap stocks. A "cheap" stock might have a low price, but that doesn't necessarily mean it's good value if the company has poor financials or weak growth prospects. Value investors dig into financial analysis to find these gems, often ignoring the latest market trends.
They focus on long-term gains by investing in companies with strong fundamentals. A great example of a value stock is Berkshire Hathaway Inc Class A (NYSE:BRK.A). While its shares may not appear "cheap," Berkshire Hathaway is considered undervalued relative to its intrinsic worth, shown through metrics like its price-to-book (P/B) ratio of around 1.5. This is relatively low and favourable for value investors, who generally consider stocks with a less stringent P/B value of less than 3.0 as their benchmark.
Additionally, Berkshire’s portfolio focuses on reliable, cash-generating industries such as financials, consumer staples, and energy rather than high-growth sectors, underscoring its stable, long-term appeal.
The concept of value investing has been around for decades. It was first developed in the 1920s by Benjamin Graham and David Dodd, who are considered the 'fathers' of the strategy. Their 1934 book, Security Analysis, laid the groundwork for this approach, focusing on thorough financial analysis and long-term investing. Benjamin Graham later mentored Warren Buffett, who is widely considered the most famous value investor of all time, refining and popularising the strategy even further.
Value investors typically avoid chasing market trends, instead looking for companies with strong fundamentals that can deliver gains over the long term.
How to identify value stocks
You'll often need to research dozens of companies before finding a true value stock. Although there is no ‘right way’ to analyse a stock, there are a few metrics that can be used when identifying the fundamentals of a value investment.
Check the P/E ratio (price - earnings): P/E Ratio (Price-Earnings): The P/E ratio measures a company's current stock price relative to its earnings per share (EPS). A low P/E ratio may indicate that the stock is undervalued, suggesting potential for growth. To find the P/E ratio, divide the stock price (P) by the company's annual EPS (E). Comparing P/E ratios within the same sector provides better insight as they can vary significantly across industries.
Next, look at the P/B ratio (price - book): this compares the company's assets to its stock price. If the stock price is lower than the asset value, and the company isn’t in financial trouble, it could be a sign the stock is undervalued. This ratio is calculated by dividing the company's current stock price per share (the “P”) by its book value per share (the “B”).
Research the EV/FCF ratio: Investors use the EV/FCF ratio (enterprise value to free cash flow) to find undervalued stocks.
Enterprise Value (EV): This represents the total value of a company, including its market capitalisation, debt, and excluding cash and cash equivalents. It provides a better measure of a company’s worth than market cap alone.
Free Cash Flow (FCF): This is the cash generated by the company after accounting for capital expenditures. FCF is crucial because it indicates how much cash is available for distribution to investors (e.g., dividends, stock buybacks).
A low ratio means the company is creating a good cash flow relative to its value, which could make the stock a great pick for long-term growth.
Value investing strategy
While crunching numbers like the P/E ratio is vital, understanding a company's qualitative strengths and weaknesses is just as important for truly gauging its value. Value investing requires balancing both financial metrics and broader business insights to identify strong opportunities.
Research and analysis
When you choose value investing as a trading strategy, it's crucial to do your homework to find potential undervalued stocks. Dive deep into the business fundamentals of the company and stay updated on market trends and economic conditions.
Reviewing financial reports like income statements and balance sheets is essential to understanding how a company stacks up against its competitors. These reports highlight crucial figures, including revenue, profit margins, debt levels, and cash flow, which help investors assess a company’s intrinsic value.
Consider qualitative factors
Value investing goes beyond numbers. Look for companies led by capable leaders with a clear vision, strong reputation, and resilience. Consider what sets a company apart - like loyal customers, innovative products, or a unique value proposition. While these qualities may not be captured in financial statements, they can reveal strengths that signal long-term success.
Invest for the long-term
Value investing requires patience, as it may take time for the market to recognise and correct the undervaluation of a stock. Value investors are willing to hold stocks for extended periods to realise gains.
Free cash flow
The cash remaining after a company has paid its bills and made investments is referred to as free cash flow (FCF). When looking for qualitative strengths for value investing, a positive FCF means the company has extra money to reinvest, pay dividends, or reduce debt – all good signs of financial health.
Benefits and risks of value investing
Benefits of value investing
Value investing is a long-term strategy that offers the chance for significant gains. By buying stocks at a discount to their intrinsic value, investors can profit when the market eventually recognises the company's true worth, and the stock price rises.
Value investing tends to be less volatile than growth investing, making it appealing to more risk-averse investors. The "margin of safety" inherent in purchasing undervalued stocks provides a cushion against errors in analysis or unforeseen negative events, offering additional protection.
Some value stocks offer consistent dividends, meaning you don’t have to wait for stock prices to rise to start seeing returns. Whether you’re reinvesting those dividends or using them as passive income, they can provide a steady stream of cash while your investments grow.
Risks of value investing
- Value investing requires advanced research and thorough stock analysis. It can take time for the market to recognise a stock’s true worth, and sometimes that realisation is slow. There’s also the risk of overestimating a company’s intrinsic value, or that a company may not recover despite appearing undervalued.
- Be aware that value stocks can be sensitive to economic cycles and might underperform during downturns, particularly if they operate in cyclical industries like automotive, industrial goods, and manufacturing. Performance in these industries is closely tied to economic conditions; they thrive during growth but struggle when the economy declines.
- Watch out for "value traps"—stocks that seem undervalued but may be cheap for a reason, like underlying issues or a declining industry. These can lead to losses if the expected improvement doesn’t happen.
Value investing FAQs
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