Value investing is a strategy that attempts to profit by buying stocks that are undervalued. The thinking behind it is that if a stock is undervalued, buying it at a low price will pay off when the actual value of the stock is recognized. The market tends to overreact to news, whether good or bad. For this reason, bad news can often send stocks plummeting in price, only to recover in the hours and days after the event takes place. This is due to the immediacy of news events causing traders to react without regard to the long-term fundamentals of the company. Fundamentals are the key to value investing and it is the fundamentals that are used to interpret stocks in value investing.
Unlike technical analysis, which identifies points in the market where probability suggests the market will move a particular way, fundamental analysis looks at the underlying value of the stock itself. The value of a stock is determined by the company underlying the stock and the business it operates.
Just like when you find a great tablet on sale, undervalued stocks are essentially “on sale.” Much as the tablet still retains its essential value no matter what you pay for it, companies that have solid fundamentals are still great companies and their stock has great potential to appreciate in value. Just as the supply and demand of tablets can beat down their price, so too can price action in the stock market beat down the price of stocks. This is often due to the overreaction by sellers based on news events as previously mentioned above.
The way value investors identify the value of stocks is through the concept of intrinsic value. Several metrics are used to identify stocks that are great values. These include:
The book value (price to book ratio) is the ratio between the company’s net worth and the stock price. A company whose net worth is the same as its stock price has a book value of 1. Thus, stocks with a book value of less than 1 are considered undervalued. Since the book value is the value of the company’s assets, it seems irrational for a company to be worth less than its assets.
The P/E ratio shows the ratio between a company’s stock price and the company’s earnings. This ratio is also sometimes referred to as the multiple. For example, companies with a high P/E ratio may be said to have a “high multiple.” The price to earnings ratio is not as easily interpreted as the book value.
A high P/E ratio can suggest that investors are willing to pay more for the company’s higher earnings growth in the future than that of companies with a lower P/E ratio. A low P/E ratio can suggest that a company is undervalued. P/E ratio can vary according to the sector that a company is in. What constitutes a high P/E ratio in one sector can be a low one in another. Young, dynamic technology companies tend to have high P/E ratios compared to older, more stable companies. It is best to judge P/E ratios in comparison with other stocks in the same sector. Generally a stock with a lower P/E ratio is seen as a better value because its stock price more closely reflects the company’s earnings.
The debt to equity ratio is a company’s stock price divided by its debt. In other words, it is the company’s total liabilities divided by the company’s total shareholder equity. A company with debt that matches the value of its shareholder equity has a D/E ratio of 1. Stocks with a D/E ratio of 0.5 or lower are generally considered to have a good D/E ratio from a value investing perspective.
Warren Buffett is perhaps the most famous value investor today. The reason Warren Buffet is so famous is simple. He gets results. He uses a strategy of long-term value investing that he learned from Benjamin Graham, one of the founding fathers of value investing. Benjamin Graham and David Dodd wrote the seminal work of value investing with 1934’s Security Analysis. Many have discounted value investing over the decades as outdated or irrelevant. But when the price of stocks become completely unhinged from their value and during the subsequent crash that often results, investors always return to the oracle of value investing for direction on how to proceed.
Value investing is no different than buying a laptop on sale. A good company with earnings potential and potential for a higher stock price is a good asset no matter what price you buy it at. Identifying good companies at low prices is what value investing is all about. When the market finally realizes the value of such companies, you will then able to profit.
Value investors use metrics like book value, P/E ratio and debt to equity ratio to identify stocks that are undervalued. Despite not being the most exciting investment style, value investing has stood the test of time and the fame of value investors like Warren Buffett and Peter Lynch are a testament to this.