One term that gets thrown around a lot when talking about the stock market is “value stocks”. You probably have heard this term before, and may have developed an interest in value stock investing. If so, you’re in good company; it happens to be the investment strategy of choice of Warren Buffett (a man who is decently famous in the investment world for one reason or the other).
Value investing is one of the best investment strategies you can adopt, whether you are a beginner or an experienced, veteran investor. Here, I’ll give you an overview of what value stocks are, how to value stocks, and what benefits you can gain from this strategy.
What Are Value Stocks?
Notice in this article I have yet to use the words ‘trade’, ‘trading’, or ‘trader’. I don’t intend to use them at all to describe value stocks, and for good reason – value investing isn’t about just “trading” stocks. It’s about finding stocks that are discounted from what they are intrinsically worth and holding onto them as they grow and appreciate in value over the years.
So, a value stock, basically, is a stock that represents “an outstanding company at a sensible price” according to Buffett. The goal is to find stocks that are underpriced according to fundamental analysis (we’ll touch on this later) and buying them with an eye for a long-term horizon instead of a short-term turnaround for quick profit.
This is virtually the opposite of day trading, which focuses on short-term gains based on the up-and-down movements of the market.
Value investors are looking for solid, dependable companies with reliable performance and earnings and a good future. These qualities drive consistent returns and gains from year to year, which is the goal of any value investor.
The strategy itself was created in the 1920’s by Ben Graham and David Dodd, two economists and investment gurus who taught at the Columbia Business School. Since then, it has become one of the prevailing investment paradigms (i.e. investment strategies, such as growth investing, dividend investing, day trading, etc.) that investors today use.
Warren Buffett is probably the most well-known proponent; others include Martin J. Whitman, Christopher Browne, Charles de Vaulx and Jean-Marie Eveillard. Eveillard became particularly famous for his stance that value investors should buy stocks on margin because the objective is to hold stocks for long-term appreciation. Margin investing can cause a person to sell a stock too early since small price decreases can turn into bigger losses on margin.
Value stocks are great and should be a component of everyone’s portfolio, but how, exactly, do you determine what is and isn’t a value stock?
Valuing a Stock for Investment
There is no magical formula for value stock investing. Even if such a formula existed, it’d still be hard to find the right stocks; if it wasn’t like this, we’d all be millionaires several times over. Still, there are tried-and-true principles of evaluating stocks to determine if they have true value and are worthy of investment capital.
One important metric used is the price-to-earnings ratio, or, the current price of the stock divided by the average earnings per share (yearly revenue divided by the number of outstanding shares). A P/E ratio tells you how “cheap” or “expensive” a stock is, relative to others in its industry. For example, tech company ABC with a P/E ratio of 8.5 is thought to be cheaper than XYZ with a P/E ratio of 12. Investors generally use this ratio to determine the level of earnings growth in the future. The market, for example, thinks XYZ is going to grow more than ABC – of course, this is not always accurate or based on common sense.
If two companies generate the same kind of financial performance, a cheaper P/E ratio is generally preferred.
Another important metric is net asset value (NAV) – a company’s total assets minus its total liabilities. For value investing, you want to find stocks that have prices discounted from what they should be compared to the company’s NAV. To find a ratio, divide the share price by the NAV; the lower the number, the more undervalued the company is.
To determine how much debt a company has, you can take a look at the company’s debt/equity ratio. This ratio compares how much financing the company has from taking on debt – typically either through institutional loans or by issuing corporate bonds – versus how much financing it has received from issuing stock. Debt is less expensive, but it must be repaid and can be murder for a company during difficult times. Plus, highly-leveraged companies – companies with a lot of debt – have a hard time growing. For these reasons, stick to companies that have lower debt/equity ratios than the industry standard.
You can also use Benjamin Graham’s formula for determining the “rational price” of a company’s stock. The formula is:
Intrinsic Value = [Earnings Per Share X (8.5 + 2g) x 4.4] / Y
In this formula, g represents a company’s five-year earnings growth estimate. Y represents the current yield on AAA corporate bonds.
Once you determine the intrinsic value, you can divide that number by the price of the stock. If the number is above one, the stock is probably undervalued; if it’s below one, it is probably overvalued. That formula isn’t a home-run formula; you should use it in conjunction with P/E ratios and NAV and other tools.
Benefits of Value Investing
What can this strategy do for you?
Well, it can provide a path for conservative growth without being subjected to the volatility that often accompanies investing in stocks that are high-growth but high-risk prospects. It also can deliver a great return on investment, since there’s a lot of upside potential.
Of course, it’s not perfect; it’s tough to accurately value a company without having some system in place for doing so. Graham’s full selection process (it’s more than the above formula) attempts to correct this and does a good job of providing solid guidelines.
In the end, value stocks represent bargains – and if you’re like any other person who spends money, bargains are always welcome.