What is Value Investing?
An investment strategy that involves choosing to put one’s money into stocks that are trading for less than what one judges their intrinsic value to be is known as value investing. These investors believe that the market overreacts to both bad and good news, which results in stock price movements that do not align with the company’s long term fundamentals. Hence, a value investor actively seeks out stocks that seem to be trading less than their intrinsic or ‘book’ value which may be underestimated by the market.
This overreaction of the market provides investors with the opportunity to profit by purchasing stocks at discounted prices. In short, value investing allows an investor to buy a high quality stock on sale. To discover the underrated stocks, a value investor will employ a range of financial analysis tools and not simply follow the herd by investing in popular stocks.
Additional Read: Growth vs Value Investing: Choosing your investment strategy
How Does Value Investing Work?
When it comes to value investing, the basic concept underlying it is quite straightforward. As long as an investor realizes the true value of something, they can save a lot of money by simply buying it on sale through value investing. Most people would agree that whether or not you purchase a new TV at full price or buy it at one-fourth of the market cost on sale, you receive the same TV with the exact screen size and image quality.
Similarly, stocks work such that a company’s stock price may change, even if its valuation remains the same. Like TVs, stocks go through periods of lower and higher demands, which leads to price fluctuations. However, these fluctuations do not change the value you extract from investing your money into these stocks. Another key comparison here is with mutual fund investing. When one starts a SIP in a mutual fund, particularly in equity investments as bonds prices do not change as much, they will see the price change as a result of market highs and lows.
However, long term analysis of equity mutual funds has revealed that they eventually grow significantly in value over time and yield reasonably higher returns than bonds. Akin to this, value investors seek out individual stocks, as they are certain that their market price will grow to reflect their inherent value at some point in the future. The detective work to discover such stocks is not simple and rewards are handsome when one is able to discover them. Value investing can be incredibly lucrative with Warren Buffet being among the popular figureheads that practice it.
Additional Read: Equity MFs see the first monthly outflow in 4 years
Tools Used to Assess Intrinsic Value
How can an investor assess the intrinsic value of a stock? In general, the intrinsic value of a stock is a combination of looking at its financial performance, cash flow, profit, revenue, in addition to some more fundamental factors like the company’s brand, target market, business model, and competitive edge. Here are some tools that can help with this assessment.
● Price-to-book (P/B) ratio
or the stock’s ‘book value.’ This tool is a measure of how the company’s assets are valued compared to its current stock price. If the price to the stock is lower than the value of the asset itself, then the stock is likely to be undervalued. Note that a company could be going through a financial hardship which may reflect similar numbers in its price to book ratio.
● Price-to-earnings (P/E) ratio
This is an indicator of the track record of the company for its earnings. It helps determine how much the stock price reflects the company’s earnings. When a stock price is not reflective of its gross earnings, it is likely to be undervalued.
● Free cash flow
This measure is the amount of cash that is generated from a company’s profits and operations once all expenditure costs have been subtracted. The free cash flow of a company includes operating expenses as well as large purchases called capital expenses. This also includes the purchase of new equipment that is meant to be upgraded. A company that has a lot of free cash flow has the luxury of investing this leftover money into the future of the business. This may involve paying dividends to shareholders, paying off company debt, and issuing any buybacks.
Many other metrics are used as well. Once a full-scale analysis is carried out, the investor can decide whether they want to purchase shares at the stock’s comparative value (intrinsic value vs current stock price) and whether it is attractive enough to take a risk and invest.
Find mutual funds to start high performing SIPs with Tata Capital’s Wealth Management Solutions. Tata Capital’s Wealth Management Solutions cover a wide range of products that include stocks, bonds, SIP mutual funds, and more that can help you finance and protect your family or business.