How Investors Look for Value Stocks
Stocks become undervalued because of the irrational behaviour of investors. Value investing schemes seek to take advantage of this irrational behaviour by buying stocks that display below average price-to-book ratios or price-to-earnings ratios, particularly if they show strong dividend yields at the same time. Provided these figures fall below a company's intrinsic value, the stocks are a good buy for value investors. This raises the need for an accurate estimation of the company's intrinsic value. This is a subjective value, and two different analysts will most likely come up with different values despite being given the same information. A “margin of safety” also needs to be incorporated when estimating intrinsic value. Both these factors will be examined in more detail later on.
Regardless of the approach taken by the investor when looking for value stocks, the business of value estimation is subjective. Some investors look at current earnings and asset value without attempting to project future growth. Others take future growth and earnings estimates into account, along with other factors such as past performance and the perceived market demand for the type of product or service. One way or another, the goal is to determine which stocks are undervalued and likely to experience growth in the near to mid-term. Much of the time, value investors will be of the opinion that the market has overreacted to public information, causing price movements that do not match the future performance potential of the underlying company.
Contradicting Other Strategies
The theory that underpins value investing is at odds with another well-known theory on financial markets, known at the efficient market hypothesis. The EMH theorises that it is not possible to beat the market because share prices account for all relevant information, which is immediately reflected in price movements. The EMH assumes that stocks always trade at their correct and fair value, making under or overvaluation impossible. The EMH also says that it is not possible for an investor to outperform the market by making shrewd stock picks or having expert timing skills. Instead, under the EMH, it is only possible to create returns by taking on higher levels of risk. Despite this contradiction with the EMH, proponents of value investing have shown that it is indeed possible for stocks to be undervalued.
The markets have demonstrated time and time again that stock prices do not necessarily reflect the true value of the underlying assets, meaning that it is indeed possible for stocks to be undervalued. Famous investor Warren Buffett has on many occasions demonstrated that value investing is not only possible, but if it is done correctly, it can also be highly profitable. This does not mean that profits from value investing are easy to come by – it takes a high level of skill to identify which stocks are undervalued and which are just cheap.
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Strong Fundamentals Are Essential
One of the main traits those following a value investing model seek is strong fundamentals – such quantifiable elements as strong earnings, regular and consistent dividends, solid cash flow and healthy book value. Value investors don't just look for the cheapest stocks, as that's not how to identify value stocks. What constitutes value is low price relative to the health of the company's fundamentals.
- Fundamentals are key to success
- Cheapest is not always best
- A low-priced, well-run company is the ideal stock target
The way value investors view their role is different to other kinds of traders. When value investors buy into a company, they will see themselves as shareholder owners, as opposed to those using trading strategies of just flipping stock for a profit. They are looking to take part ownership of high-quality companies through their stock investment and will view the companies as assets, rather than a means to an asset. Their method is based around being aware of a company's worth, so they largely ignore outside influencing factors, such as the state of the overall market and price fluctuations, and concentrate on the appropriate and responsible operation of the business. Fundamentals rule over market forces for value investors.
Ways to Identify Potential Target Shares
The next step in becoming a value investor is to perform a broker comparison and establish which is the best source for stock purchases. Once you have decided on a place to purchase stocks, it's time to narrow down which ones are the best for this kind of strategy. Value stocks trade on all the major worldwide stock exchanges, and these exchanges can be accessed through online brokerages. There is no specific sector where you are most likely to find value stocks, but there are some common traits to look for. The price-to-intrinsic value ratio is important. The share price should be no more than two-thirds the intrinsic value of the stock.
There are various advisory agencies and expert analysts that will give their opinion on stocks' intrinsic value. Look for a low price-to-earnings ratio. This is a measure of the share price to the earnings per share. It can be calculated by dividing the share price by its most recent earnings-per-share figure. A value stock will be no more than 40% of its highest price-to-earnings ratio from the past five years. Shares with a low price-to-book ratio make good value shares. This figure is the current value divided by the book value from the latest earnings report. Once you have this value, compare it to averages from other companies in the sector.
Further Signs a Stock is Suitable
There are some other figures to examine when assessing a company's suitability for value investing. It is important not to skip over any of these measures, as the key to success is only moving forward on stocks that tick the right boxes and not risking any investment on shares that are not quite fit for purpose just to save time or reduce the amount of work needed. Seek out shares with a low price/earnings to growth ratio, a measure of stock value derived from a company's earnings growth. This figure is gained by dividing the price-earnings ratio figure by the amount the company's earnings have grown over a specific time period. Investors looking for value stocks will aim for a price/earnings to growth ratio of below one. Be careful of companies that are too heavily leveraged. A low debt-to-equity ratio indicates the company does not owe too much debt. This figure can be realised by dividing total liabilities by the amount of stockholder equity. Once this figure is established, it should only be compared with companies in the same sector or industry to give a fair and accurate idea of whether the figure is low or not. Different sectors can be leveraged at greatly differing ratios, so it is important to be objective. Finally, the company dividend yield needs to be at least two-thirds of the current AAA-rated long-term bonds. This is an extra measure to be sure of having shares that will outperform.
RSI, or Relative Strength Index, is a technical indicator used by traders to monitor markets and make wiser investment decisions. RSI works by comparing recent gains and losses in a market in order [...] Momentum traders are similar to trend traders in that they monitor movement in market prices and look for upward or downward trends they can take advantage of. They take either a long or short posi [...]
RSI, or Relative Strength Index, is a technical indicator used by traders to monitor markets and make wiser investment decisions. RSI works by comparing recent gains and losses in a market in order [...]
Momentum traders are similar to trend traders in that they monitor movement in market prices and look for upward or downward trends they can take advantage of. They take either a long or short posi [...]
Intrinsic Value and Margin of Safety
Intrinsic value is one of the primary figures that needs to be established for each stock being assessed for suitability as a value investment. In all the examples above, the intrinsic value is a benchmark against which the true value of the stock can be measured, and it is the key to knowing whether a stock is undervalued or not. Once the intrinsic value is established, traders also need to factor in a margin of safety, which acts as a buffer should the true intrinsic value be lower than estimates. This buffer limits the amount of unexpected downside exposure investors would otherwise have to deal with.
- Make sure intrinsic value estimates are accurate
- Always factor in a margin of safety
- Don't forget to examine fundamentals against intrinsic value
The importance of intrinsic value cannot be stressed enough, especially for beginners who are researching which stocks will add suitable value to a new portfolio. This, along with a thorough application of the analysis of fundamentals mentioned above, will go a long way to averting disasters further down the track. That said, estimating intrinsic value can be tricky. Analytics companies will put forward their own intrinsic value estimates, but it is not a good idea to rely on a single source. Instead, collect several values from multiple sources and look at the average to gain a better idea of the true intrinsic value. Then, on top of that, remember to factor in your margin of safety.
Take Tips from a Pro
Value investing has some high-profile proponents. As mentioned earlier on, Warren Buffett is one of the most famous investors in the world, and this is one of his favoured strategies. He has some tips for success that are worth noting.
- Diversification is not always best. When investing long-term, a few good picks are better and easier to track than many smaller ones.
- Your best investment is in yourself. Make sure you are able to consistently make money regardless of how you do it. Don't spend too much time investing if you are not making it your career.
- Trust yourself. Once you have put in the work and come to a decision, stick by it and remember how you came to your decisions. Don't second-guess your best judgement.
- Don't get out of your depth. It's important to stay within your scope of understanding. If someone tries to talk you into investing in a business that you are not 100% clear about, walk away.
- Pick your news sources carefully. This is particularly true today in the age of clickbait and fake news. Be sure sources upon which you base stock-picking decisions are reputable.
- Learn from your mistakes. If you lose, take the lesson, be sure you understand what happened and why, then move on.
- Avoid day trading. Long-term strategies create better profits, as they are more like real business and less like playing table games in a casino.
Keep these tips in mind before you begin trading.
Our Verdict on Value Investing
No investment model is perfect, and there are no guarantees when it comes to the stock market. It is entirely possible to follow all the guidelines laid out above and still lose your investment. However, these methods have been tried and tested over time by professionals, and it makes logical sense that if you work hard at getting your strategy right, there will be a payoff at the end.
Making sure your analysis of fundamentals is thorough, avoiding being rash or impatient when it comes to locating undervalued stocks in which to invest, ensuring your company picks are in good financial health and being accurate with intrinsic values and margins of safety will go a long way to mitigating risk. While some losses are unavoidable and usually come from unforeseen events, it is possible to create a portfolio that is not overexposed to risk, while still generating acceptable returns. It really depends how much work you are prepared to put into ensuring you hold the right stocks that suit this type of strategy.