Does Value Investing mean knowing the true potential of the Stock?
Value investing is an investment strategy where you invest in stocks that you think are trading for less than their intrinsic or book value.
Let’s understand everything about value investing in this article. Keep reading.
Ever met people who according to you were too bright to be kept doing what they were in their lives? For example, Mahendra Singh Dhoni. When he was working as a Ticket Collector with the Indian Railways, very few could see that he was meant for bigger things. Those people saw ‘value’ in Dhoni.
Had Dhoni been a “stock” and those people could have invested in him, they would have made billions after Dhoni excelled in the cricket world. This is what value investing is – spotting a stock trading below its true worth and investing in it with the belief that it will grow multi-folds.
- What is Value Investing?
- Top Fundamental Factors for selecting value investing stocks
- Advantages of Value Investing
- Disadvantages of Value Investing
- Value Investing vs Growth Investing
- Quick Summary
What is Value Investing?
Value investing is an investment strategy where you invest in stocks that you think are trading for less than their intrinsic or book value. Intrinsic value is what the stock is really or truly worth. Value investors look for stocks whose market price is below their intrinsic/true value. They invest in such stocks in the hope that sooner or later the Stock Market will give the stock its due.
Human behavior is such that we tend to pay a higher price on rising stocks, thus buying it at much higher levels than its true value and staying away from stocks that have fallen quite a bit. Value investors have the acumen to read into the financials and spot attractive opportunities hidden from the stock market.“Buy not on optimism, but on arithmetic,” says Benjamin Graham, who is called the father of value investing. His follower Warren Buffett has become much more famous than his Guru following his value investment approach.
Top Fundamental Factors for selecting value investing stocks
Graham has defined seven factors to select ‘value’ stocks in his book, ‘The Intelligent Investor.’ Here goes a brief:
1. Quality rating
He advises selecting companies with average or better ratings. One doesn’t have to pick the top-rated companies. Those just have to be better than the most. For example, Standard & Poor’s (S&P) rating system ranges from D to A+. An S&P Earnings and Dividend Rating of B or better will work for companies rated by Standard & Poor’s.
2. Debt to current asset ratio
Debt is a significant metric to look at when investing in a company. Graham suggests investing in companies with total debt to the current ratio of less than 1.10.
3. Current ratio
The current ratio is calculated by dividing current assets by current liabilities. A ratio above 1.50 suggests investment comfort, according to Graham.
4. Positive earnings per share growth
Look into the earnings per share for the last five years. There should not be earnings deficit in any of the years. Choose companies with consistent earnings growth. Stay clear from the ones with choppy earnings growth.
5. P/E ratio
In the PE ratio, P stands for price and E, earnings per share. PE ratio tells you how much the market is willing to pay for stock against its earnings per share.
Graham says to invest in companies with P/E ratios of 9.0 or less. This will help you in bargain hunting.
6. Price to book value
Price to book value or P/BV is an important financial metric. It is calculated by dividing the current price by the most recent book value per share of a company. A ratio less than 1.20 is considered safe.
When investing in a value stock, the wait for a jump in its market price could be long and tedious. That said, your value pick should be a stock that pays dividends. There may not be a price rise for quite a few years, but at least you will reap dividends.
Advantages of Value Investing
- You get to invest in quality companies at lower levels – thus the potential for landing multi-baggers.
- It’s a proven strategy given Graham has been using it since 1928, and Warren Buffett still talks about it in his annual letters and meetings.
- Value investing is based on thorough fundamental analysis. It leaves no scope for speculation.
Disadvantages of Value Investing
- Value investment is complex. Any error and one may catch hold of a ‘value’ trap, which does have lower valuations, but no potential for growth.
- Value investment requires patience. The waiting period could be in years. One needs strong conviction to stay invested in value stocks.
- Value investment may not give you enough diversification. It is hard to find value buys in each sector that you need for diversification.
Value Investing vs Growth Investing
- Value investing is about taking exposure in undervalued stocks, while growth investing focuses on overvalued companies with their strong future growth potential which is visible to all.
- Growth stocks are mostly the ones with a relatively new-age business model which has many takers. Value stocks are relatively older and well-established companies that are not in the limelight.
One cannot say which approach is better than the other. It is about personal preference. In India, which is a growth economy, growth stocks are preferred, but those trade at a premium. Value investing is popular too. There are in fact mutual funds specifically picking stocks based on value investing factors. These are called value funds.
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, and hence we bring you the important topics and areas that you should know:
“The secret to investing is to figure out the value of something — and then pay a lot less,” says Joel Greenblatt. This is value investing in one sentence. One needs thorough fundamental analysis and conviction in it to pick value stocks. Once you have a couple of ‘Dhonis’ in your portfolio, the cricket world (read the stock market) will be yours.