Value investing is an investment model that focuses on large companies that are listed below their intrinsic value, based on quantitative and qualitative indicators. Investors who utilise the value investment approach believe that the market is pricing the stock or share incorrectly against its intrinsic value, and that the price will increase as the intrinsic value is realised.
Qualitative variables include things like the company’s business strategy, governance, and target markets. Financial ratios and financial statement analysis are examples of quantitative variables in fundamental analysis. These elements are indicators of the company’s performance. Investors’ views of an asset’s relative value are captured by perceptual variables. Technical analysis helps to explain many of these variables.
This article will help you to know how to spot value investments.
Table of Contents
What Is Value Investing?
Value investing is meant to minimise risk by improving the knowledge of what you invest in, so you can make smarter investment choices and buy at a price that offers you a margin of safety. To understand this investment strategy, it is important to have a look at the history of value investing and its most famous investors.
The History of Value Investing
Over the decades, value investing has changed. Its origins date all the way back to the Great Depression and its aftermath, when the strategy’s only objective was to invest in businesses that exhibited a lower price than their net tangible assets value. Another term that describes this phenomenon is “tangible equity.”
However, value investing has evolved into a more basic examination of a company’s cash flows and profits. In addition, value investors consider the competitive advantages of a business when deciding if a stock is substantially undervalued.
Famous Value Investors
Benjamin Graham, widely regarded as the “Father of Value Investing,” coined the phrase in 1949 with the publication of his seminal book: The Intelligent Investor. Warren Buffett, Seth Klarman, Bill Ruane, and Martin Whitman are among notable proponents of value investing.
Benjamin Graham’s framework of value investing aimed to create a simple stock screening procedure that the ordinary investor could use. Overall, he kept things simple, but traditional value investing is more complicated than simply repeating the mantra, “Buy stocks with a price-to-book (P/B) ratio of less than 1.0.” Graham believed that determining a company’s worth was as simple as looking at its financial statements. There was no need to look at qualitative aspects like a company’s leadership, future product offers, and so on.
Along with the quantitative criteria, Warren Buffett’s methodology determined that the success of a company is influenced by these qualitative aspects:
- Management quality
- Industry dynamics
- Future goods
- Customer behaviour
Furthermore, Buffett does not always follow Graham’s rule of diversification: he likes to focus his assets on specific businesses. Buffett gradually shifted away from Graham’s rigorous approach and started to focus on purchasing excellent companies.
While much credit for Buffett’s education goes to Graham, Buffett has said that he is “85% Graham and 15% Fisher.” Philip Fisher (1907–2004) was a well-known investor and author who is best known for his publication: “Common Stocks and Uncommon Profits.” One of the most valuable lessons implemented by Buffett from Fisher’s approach was to buy good businesses at a fair price, rather than risky businesses at a cheap price. His fundamental investing strategy was to put money into a limited number of businesses with bright prospects and then do nothing.
How Does Value Investing Work?
Value investing works according to the idea that some stocks are under or overvalued. Value investors believe that by identifying an undervalued stock, they will receive improved returns when the markets understand the pricing mistake and the stock reaches its “true” value. This rejects the efficient market hypothesis.
Markets Are Not Efficient
The efficient market hypothesis (EMH) is based on the assumptions that:
- Share prices reflect all information
- Share prices follow a random evolution
- And so the market value is efficient
This means that stock prices are decided by today’s news rather than yesterday’s patterns, leading to the conclusion that the market is efficient all the time. The EMH states that stock prices automatically consider all available information about a business.
However, this is where value investors differ in their thinking, as they believe that companies may be over or undervalued. While the market is efficient most of the time, there are opportunities for investors who can find undervalued stocks. As Buffett once said:
“I’d be a bum on the street with a tin cup if the markets were always efficient.”
What Are Value Stocks (Intrinsic Value)?
If you can discover undervalued shares, certain trading possibilities may be unlocked. So, which methods do investors use to identify undervalued stocks? As part of their fundamental analysis, they mostly rely on the use of ratios, cash flows and other indicators.
Identifying a Value Stock
Value investing requires extensive study, both in terms of quantitative and qualitative analysis. Before making any decision, it is paramount to perform your research by going through numerous unfavourable stocks in order to evaluate the intrinsic worth of a business and compare it to its current share price. The intrinsic value is a mix of:
- Financial analysis, such as examination of a firm’s financial performance
- Cash flow and profit
- Fundamental variables such as its brand; its business model, the objective market, and its competitive advantage
This process will take some time — you sometimes have to look at dozens of businesses before you discover a single company that is a genuine value stock. For this pursuit, investors use several measures to try to determine a stock’s intrinsic worth.
Free Cash Flow
Free cash flow is the amount of money that a company has left over after paying all of its debts, investing in the firm’s future, paying dividends or other incentives to shareholders, and issuing share buybacks. Increased free cash flows should result in an increase in the value of the company’s shares.
The ratio of the stock price to free cash flow per share is a way of determining the worth of a company’s shares. Comparing a company’s price-to-free-cash flow ratio to that of other businesses, industry standards, and historical trends may give some indication of its relative worth, just as the conventional price-earnings ratio can provide an indication of its relative value. Firms with low price-to-free-cash flow ratios may be undervalued companies with good pricing opportunities.
Return on Invested Capital (ROIC) and Return on Equity (ROE)
Another useful indicator is return on invested capital (ROIC). In essence, ROIC represents the amount of money a company makes that is higher than the average cost of debt and equity capital that it incurs during the year. A return on equity (ROE) is similar to a return on capital, in that it measures management’s capacity to produce revenue from the equity that is available to it — a ROE of 15–20% is usually regarded as satisfactory.
eToro Popular Value Investors
For any beginner, it would be a good idea to make use of our CopyTrader feature, which allows you to follow the decisions of Popular Investors. A Value Investor on eToro is a Popular Investor who follows the criteria mentioned in their investment decisions.
Margin of Safety
Value investors must allow for some inaccuracy in their value estimate, and they often establish their individual “margin of safety” depending on their own risk appetite. It is based on the concept that purchasing stocks at a discounted price to their intrinsic value enhances your chances of making a profit when you sell them later. The margin of safety theory is one of the keys to effective value investing. In addition, if the stock does not perform as anticipated, you will be less likely to suffer a financial loss.
Value Investing Performance
In the past, value investing has shown to be a profitable investment strategy for investors. There are a variety of methods for determining success.
One approach is to look at the success of basic value strategies, such as:
- Purchasing companies with a low price-to-earnings ratio
- A low price-to-cash-flow ratio
- A low price-to-book ratio
Nonetheless, it is important to bear in mind that this more statistical style mainly promoted by Graham is not sufficient today: qualitative factors are equally, or even more, important.
Past research has repeatedly shown that value companies outperform growth firms as well as the overall market over the long term. A study of 26 years of data (1990–2015) from the US stock market discovered that the over-performance of value investing was more pronounced in stocks of smaller and mid-size companies than in stocks of larger companies. The study recommended a “value tilt,” in which personal portfolios place a greater emphasis on value investing rather than on growth investing.
Value Investing vs. Growth Investing
Individual investors’ preferences and their own risk tolerance, financial objectives, and time frame ultimately determine whether they should invest in growth or value companies. It should be emphasised that, during shorter periods, the performance of either growth or value will be influenced significantly by the cycle stage in which the market is now located.
Because they are often found in bigger, more established businesses, value stocks are believed to have a reduced degree of risk and volatility. And even if they don’t return to the target price that analysts or investors expect, they may still provide some capital growth. These companies are also often dividend payers and capital gain producers. On the other hand, companies with growth stocks will often abstain from paying dividends in order to reinvest retained profits back into the business. Growth stocks may also have a higher risk of loss for investors, especially if the business cannot maintain growth rates expected by the market at large.
Growth stocks are considered to be riskier investments. In terms of increasing the value of your portfolio, they are seen as an aggressive strategy. Growth stocks outpace the general stock market, providing greater rates of return than the overall stock market. Instead of concentrating on income or dividends, this kind of business is more concerned with development and expansion.
Risks and Criticisms of Value Investing Performance
Despite the fact that value investing is a low-to-medium-risk approach, there is always the possibility of losing money when investing in stocks. Nonetheless, there are a variety of methods to avoid a negative outcome.
Do Your Homework – Have All the Current Facts and Accurate Data
You must have the discipline and dedication to adhere to your investing philosophy. When it comes to certain companies, you may want to purchase their stocks because the fundamentals are good, but you might have to postpone if the stock is overvalued. Ideally, you’ll choose to purchase the stock that is most attractively priced at the time; but, if no stocks fit your requirements, you’ll have to sit and wait, allowing your capital to accumulate until a chance presents itself.
Portfolio Diversification – Don’t Put “All Your Eggs in One Basket”
Traditional financial knowledge holds that investing in individual stocks is a high-risk approach that should be avoided whenever possible. We are urged to diversify our investments among a number of companies or stock indexes to get exposure to a diverse range of businesses and economic sectors. However, diversity is a relative concept, differing from investor to investor. Some value investors think that you can have a varied portfolio even if you hold a limited number of companies’ stock. Others feel that you can have a diversified portfolio even if you buy stocks that represent a diverse range of industries and sectors of the economy.
Value Traps — Where Value Stocks Are Not Value Stocks
A value trap is a stock that seems to be inexpensive, but is really more expensive than it appears.
When evaluating a stock, bear in mind that the future of a business is more essential than its history. This will help you to avoid falling into a value trap. You’ll be more likely to discover genuine value stocks if you concentrate on a company’s potential for sales and profits growth in the months and years to come rather than on its past performance.
The profits of stocks in cyclical sectors such as manufacturing and construction are often boosted significantly during boom times, only to have a significant portion of those earnings vanish when business circumstances deteriorate. When investors anticipate that a company will go bankrupt, the firm’s value will seem very cheap compared to current profits — but this will become much less so if earnings decline during the weakest economic portion. Nonetheless, stocks in industries that strongly emphasise intellectual property are more likely to become value traps.
Value Investing in a Bear Market – Potential Pitfalls of Buying Value Stocks in a Falling Market
Because of their lower price-to-earnings ratios and anticipated earnings stability, value companies may outperform the main market indexes during a downturn (meaning they will decline, but not as much as the broad market indices). A bonus feature of value stocks is that they often pay dividends, which become more valuable than the money you invest when equity growth (the value of the company’s stock) slows or declines. When experiencing a bull market, value stocks tend to be overlooked. Still, when the bull market ends, there is typically an inflow of investor money and widespread interest in these steady, successful businesses. However, the problem with purchasing stocks during a bear market is that, even though they may seem cheap at one point, prices may still fall in tandem with the market.
Value Investing in a Bull Market — Buying Value Stocks in a Growing Market
Value investors must also be able to withstand setbacks. Because it eliminates many more companies than it discovers, value investing may be a very difficult method to employ during a bull market. Many of the companies you cross off your purchase list throughout your search will continue to rise in value during bull markets, despite the fact that you once considered them too costly. Therefore, one disadvantage of not purchasing stocks during a bull market is that, although they may seem overpriced at one point, prices may continue to increase in tandem with the market. However, the payoff comes when the bull market comes to an end, since the margin of safety provided by value stocks may make it easier to weather a downturn.
When looking for businesses to invest in, value investors look for companies that seem undervalued, meaning that their assets or profit potential aren’t completely represented in the stock price. They expect to benefit if and when other investors see the worth of the company and the stock price increases to reflect this recognition.
If value investing is successful, investors stand to win on both sides of the table. Not only do their earnings increase, but this also instills confidence in investors, who are willing to pay larger valuation multiples for the stocks, resulting in an even greater increase in their share prices.
Overall, value stocks have outpaced the general market by a significant margin, and cheap stocks have generally recovered — either because the conditions that caused them to be cheap proved to be temporary or because the company’s management discovered a way to turn them around.
To summarise, value investment is concerned with:
- Solid fundamental analysis
- Identifying and purchasing cheap stocks (relative to their intrinsic value)
- Purchasing stocks a safety margin
Get started with value investing on eToro!
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.