What is value investing?
Value investing involves finding and buying stocks that appear to be undervalued. They are shares that have been unloved, which investors believe to be unjustifiably “cheap”. It is an alternative strategy to investing for growth.
The theory is based on the premises that the stock market does not operate in an efficient and rational way. It suggests that investors overreact to news (both good and bad). The effect this has is to drive share prices up and down in way that doesn’t necessarily reflect the health of a company’s underlying business and long-term prospects.
The value investing strategy
With the stock market it can be easy at times to get “tunnel vision” and get hung up on share price growth. The share price of a particular stock has risen 200% in two years. Does that mean the business is strong and healthy with good long-term prospects? Or has it just caught a short-term wave of growth in the sector or market? This kind of growth is something that makes value investors dubious. Investors adopting the value approach are likely to turn the other way and find a more neglected stock. Once they do, they will lift the bonnet of the company and take a closer inspection to evaluate the business.
Value investors will study a company’s fundamentals. This could include revenue, profit, cashflow, debt, balance sheet, financial ratios. Their goal is to understand the financial health of the underlying business. Ultimately, they are looking to decide whether the seemingly “cheap” share price is justified.
You might think of value investors as shopping in the sale section of the stock market. The difficulty, like a Black Friday sale, is knowing if you are getting a bargain or whether it is too good to be true.
Finding value stocks
Stocks seen as value stocks are those that are trading for less than their intrinsic or book value. Intrinsic value is a method of valuing a business. It’s not an exact science and there a multiple views and methods on determining the value.
[warning – short maths explanation ahead]
The school of thought that Warren Buffett has previously discussed is the idea of using cashflow as the basis for the valuation.
Under this model, an investor would try to estimate the future cashflows the business will receive. They would then “discount” these future cashflows to reflect the concept of the time value of money. This concept states owning £1 today is worth more than £1 tomorrow. This process is called discounted cashflow analysis. We will cover this calculation in more depth another day.
To estimate future cashflows the investor has to understand the business. By this we mean it’s strengths and weaknesses, the competitors in the industry and the general prospects of the sector. Value investors will often favour stable companies that have a good level of information available to help them with this. Such as big FTSE 100 and FTSE 250 companies rather than those on AIM for example.
Another method that may be used in tandem is analysing the company’ price-to-earnings ratio (P/E). This is the company’s share price divided by its earnings per share. You will often see this ratio quoted on the financial details section when viewing a stock on your chosen share dealing platform.
A third method may involve studying the company’s assets and liabilities and comparing these to other companies.
[maths explanation over]
Where does value investing originate from?
Legendary investor Warren Buffett has been a public advocate of value investing over the years. However, it’s actually Buffett’s mentor Benjamin Graham who is known as “the father of value investing”, releasing a book on the subject as long ago as 1949.
Graham was a professor at Columbia Business School and a professional investor. Graham championed the strategy of buying stocks based on the underlying financials of the business and promoted taking a long-term view to achieving investment goals.
Why value stocks?
So why would you seek value stocks? Well value investors believe if they get it right and do truly find a stock that is “under-priced” or “discounted” they will profit from the stock rising to its “proper” value in the long-term. It is important to remember that value investing is a long-term strategy requiring patience. Also, the principles of diversifying your portfolio still apply.
If you’re keen to learn more make sure you check out the rest of our website or grab a copy of our free Beginner’s Guide to Investing in the Stock Market.
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