Value investing is an extremely popular strategy for growing wealth over time. Put simply, value investing entails buying and holding stocks that traders believe the market has undervalued. Some of the best-known names in market circles – Warren Buffett and Charlie Munger, among them – are investors who made their fortunes through value investing.
If you’re interested in investing in stocks using the value investing strategy, you’ll want to learn more. In this guide, we’ll explain what value investing is, how it works, and how you can begin investing in value stocks.
What Is Value Investing?
Value investing is a strategy in which investors buy stocks that are undervalued by the market and hold them until they reach their potential value. This strategy assumes that, if a stock is trading below the intrinsic value of the company, then the market will eventually adjust to reflect the intrinsic value. When that happens, traders who bought the stock when it was undervalued will turn a profit.
Importantly, value investing isn’t always straightforward. Knowing when a stock is undervalued requires making assumptions about the company’s potential growth, the direction of technology and consumer trends, and more. Value investors must contend with the fact that a stock’s intrinsic value can drop over time if the underlying company doesn’t meet its projected growth.
Why Do Value Investments Exist?
Value investing requires that some stocks are underpriced in the stock market relative to their real value. In theory, if the market were fully efficient and traders were fully informed about every company all the time, there would be never be a value investment – traders would always buy and sell shares until the stock price was exactly at its intrinsic value.
But of course, the market is anything but fully informed – in fact, there are many potential reasons why a stock could be undervalued. It could be that the market overreacts to a piece of bad news, leading to a short-term disparity between what a stock is trading at and what a company is worth on paper. The same overreaction can happen during a stock market crash or even during a pullback in the middle of a broader bullish trend.
Alternatively, some stocks have simply gone unnoticed. The vast majority of trading that takes place each day is for shares of companies in the S&P 500. But, there may be many small-cap or foreign companies that have a lot of potential. If traders don’t realize these companies are on the market, they can trade well below their actual value.
How Do You Start Value Investing?
The most important part of value investing is understanding how to calculate the intrinsic value of a stock. This is the price that defines value investing – when a stock is trading below its intrinsic value, it’s a bargain. When it’s trading above its intrinsic value, it’s overpriced.
Calculating Intrinsic Value
There’s no single formula for calculating the true value of a stock. Most value investors rely on a combination of fundamental metrics, such as the price-to-earnings ratio, the price-to-book ratio, and profit.
However, these metrics aren’t perfect. They also fail to capture some of the less tangible things that investors must consider when calculating intrinsic value, such as growth potential. If there was a single, perfect way to calculate intrinsic value, there would likely never be an undervalued stock to be found.
Since there is no perfect calculation of intrinsic value, value investors must set a margin of safety when calculating the intrinsic value of a stock and trading.
You can either assess intrinsic value very conservatively, using conservative assumptions and projections that deliver a lower calculated value. Or, you can trade a stock only when the stock price is significantly below your calculated intrinsic value. Using both of these techniques in combination helps ensure that you have a large margin of safety and can profit even when you overestimate the intrinsic value of a company.
Finding Value Stocks
How do you go about finding stocks that are potentially undervalued, or may be after a market downturn? There are several common strategies that value investors use to find trading opportunities.
One of the easiest ways to home in on stocks that might be undervalued is to look for insider buying activity. Insiders are members of the company’s executive team or shareholder that own more than 10% of the company.
These investors are often extremely well-informed about a company’s financial position and outlook – in effect, they represent “smart” money when it comes to that particular company. If the CEO is buying millions of dollars’ worth of shares, it may be because they think the stock price doesn’t accurately reflect the company’s future growth.
Another way to find potential value investments is to look at fundamental metrics for multiple companies in the same industry or market sector. Is one company trading at a lower price, relative to its earnings or revenue, than many of its competitors in the same sector? If so, look closely at the company to see if there is a reason why and whether that reason accurately reflects the future earnings potential of the company.
Quarterly and annual financial statements contain much of the information you need to calculate the intrinsic value of a company. You’ll find details on revenue, cash flow, debt, and much more inside these statements. Reading them is one of the best way to not only get an in-depth look at a company’s financial situation, but also to get a sense of whether the company is growing or stagnating.
Follow the Gurus
One of the nice things about value investing for the everyday investor is that there is plenty of good advice to follow. Warren Buffett, arguably the most successful of all value investors, frequently releases lists of the companies that he is invested in. These lists, along with the portfolios of other well-known value investors, are a good place to start for finding trading opportunities.
Conclusion: Value Investing
Value investing is a long-term and relatively low-risk trading strategy with plenty of potential upside. That said, value investors must be patient and diligent – the biggest risk that value investors face is overpaying for a stock and thus reducing their margin of safety. If you’re interested in value investing, one of the best ways to get started is to find out what stocks other value investors are following and complete your own analysis of their intrinsic values.