What Are Value Stocks in Investing?

A value stocks can be loosely defined as companies or stocks that are trading for valuations that are below the overall stock market average. - Investingport

Value stocks are stocks trade relatively lower than the intrinsic value of a company. The intrinsic value of a company is an evaluation that is subjective to various fundamentals of the business such as the company’s net assets and/or the future potentials of the company in the market. And stocks that fit this description tend to overperform the market year over year.

Value Stock Explained

A valued stock is characterized by high dividend yield, low P/B ratio and/or a low P/E ratio. Another characteristic of the value stock is that its equity price is typically lower than the stock prices of many companies within a particular industry.

There are certain fundamentals that a value investor must consider to determine the value of a company such as earnings, sales, or dividends. In order to achieve this, the investor would put into consideration the market price alongside the value of the company. If the market price is lower than the value of the company, the stock is considered as a value stock or undervalued. This can also be referred to as a bargain-price which enables investors to see a company as unfavorable in the market place. It is possible that different investors may determine the value of a business based on their individual perceptions and understanding of the business fundamentals. As a result of this, a company’s intrinsic value will differ by investors.

Usually, the market price of company stock is determined on stock exchanges based on the prices bid and offers by the investors. Prices are bound to change at any time and can be easily determined by comparing previous trade prices.

How to Invest in Value Stocks

Value investing basically has to do with the identification of stocks that trade at a discount relative to their intrinsic value and investing in them. Contrary to simply stating it, a lot of work goes into finding undervalued stocks, hence the need for the different approaches to finding the value of a stock.

Investing in value stocks requires that the investor is able to find stocks that are trading at a discount to the true value of the business. Since the market determines the prices of a stock, an investor who invests in value stock does so in hope that the market would soon discover the true value of the company, and would cause its stock prices to increase at a fast rate. When this happens, the investors who purchased the stocks at a discounted rate or undervalued rate would make profits off the new market price.

Value investors must be sharp to quickly identify market bargains that are done at a discounted rate. For example, an investor is able to purchase $100 bills at a price lower than $100. But to arrive at this, the investor must be deliberate about their findings. If a company out rightly bargained its stocks for a discount rate if would be rushed in no time and the bargain wouldn’t last. It is therefore left for value investors to beat other investors to it by carrying out their own findings.

Typical Approaches to Finding a Value Stock

As earlier stated, a valued stock is characterized by its earnings yields, price to earnings ratios (P/E ratio), price to book ratio (P/B ratio), and price to sales multiple (P/S ratio). These financial ratios are typically used to determine if a stock is trading at an attractive valuation.

These financial ratios are not to be used to make final conclusions or judgments about the value of a company as ratio analysis differs across industries. They may differ according to the growth or age of a company. Some companies that are asset-heavy may be better assessed using the price to book ratio to determine the value of a stock compared to using another financial ratio or ratio analysis. While other companies that are asset light but service heavy may require the application of revenue, P/E ratios, growth rate, etc., to determine its value. To account for higher future growth, a price-earnings to growth ratio (PEG ratio) can be used to scale price-earnings (P/E) multiple.

Other approaches to determining the value of a company include variations of the Discounted Cash Flow analysis. This analysis focuses on finding the present value (PV) of the cash a company is expected to generate for its shareholders in the future. However, this is not a reliable analysis considering the fact that predicting future cash flow is mostly inaccurate. The discount rate also has to be put into consideration to identify the possible risks involved in making such an investment. This method can still be considered if the investors are willing and able to breakdown business operations.

Terms Explained

Book Value: A company’s book value is the value of its assets minus the liabilities. It can be calculated on the company’s balance sheet. Book value can also be calculated on a per share basis by dividing the per-share number by the number of outstanding shares a company has. Finding the book value of a company would help the investor determine whether a company is underpriced or not.

Cash Flow: This is simply defined as the difference between the cash that flows into a company’s accounts and the cash that flows out of a company’s accounts. For example, if a company pays a total of $70 million into its accounts in a particular quarter and takes out $30 million within the same quarter, its cash flow would be said to be $40 million. It is required of public listed companies to release a statement of their cash flow alongside other quarterly financial reports.

Cash Flow Multiple: This is a metric used to clear up any existing distortion in a company’s reported earnings. It is also referred to as price-to-cash flow ratio or EBITDA multiple.

Discounted Cash Flow: This is a mathematical method whereby investors find the value of a company by assessing the future value of the company’s cash flows. That is, determining how much a company may worth in the future based on its current value.

EBITDA: Earnings before interests, taxes, depreciation, and amortization (EBITDA) plays a significant role in several value investing metrics. It is thought to give an apples-to-apples version of earnings than net income. EBITDA helps to account for distortions such as depreciation deductions which reduce net income.

Price to earnings ratio (P/E ratio): This is an investing metric. It can be calculated by dividing a company’s share price by its annual earnings. This metric can either be applied to a company’s last 12 months or earnings (trailing 12 months earnings, or TTM earnings) or a company’s next 12 months of projected earnings (forward earnings).

Price to earnings growth ratio (PEG ratio): This is a growth investing metric that can be applied to value investing. The PEG can be calculated by dividing a company’s P/E ratio by its annualized growth rate. It provides an apples-to-apples comparison method for different companies growing at different rates.  

Price to book ratio (P/B ratio): A company’s book value is what is left of the company if it ceases to operate after paying off its debt and selling its assets. By using the price to book ratio, an investor can calculate a company’s share price as a multiple of its book value. By doing so, the investor would be able to determine how expensive or inexpensive companies within a particular industry are trading for. The P/B ratio would also help the investor find companies that trade below their book value but have strong business fundamentals.

Conclusion

Not all companies can be said to possess value stocks. Value stocks are preferably long-established companies that have steady growth rates, consistent profitability, and stable revenue. They are companies that may not be so popular among investors but hold great potentials to appreciate in value over time. Investors who choose to invest in value stocks must be prepared to go long term and at a slow but steady rate.

Investors who master this type of investing strategy will eventually have an advantage in buy-and-hold investing. They will be able to accurately interpret the market to know when precisely to buy a stock, when to hold, for how long to hold, and when to sell a stock.