What is value investing and how does it work?
Updated: July 26, 2024
If you’re already investing and want to take your stock picking to the next level, you should know about value investing. Value investing is a strategy where investors rely on public financial information to determine if a stock is undervalued and poised to do well in the future. Here’s a closer look at what value investing is and how you can add it to your portfolio management strategy.
What is value investing?
Value investing is a stock analysis method that identifies stocks trading below its intrinsic value. For example, if you believe a stock is worth $50 per share but the current market price is $35 per share, you’ve spotted a potentially lucrative value investment opportunity.
As the name implies, the core of value investing is figuring out a stock's true value. That part is easier said than done, but successful investors like Warren Buffett prove that it’s possible to have a successful long-term stock portfolio that relies on the fundamentals of value investing.
The concept of value investing was developed and popularized by Benjamin Graham, (who happened to be my grandfather’s college finance professor) primarily through his bestselling book, first published in 1949. While the technologies we use to identify and invest in value stocks have changed dramatically, the fundamentals of value investing remain the same as it was first described in the 1940s.
How to invest in value stocks
To better understand how value investing works, here’s an example of how someone could identify a value stock.
- 1.
Choose a potential candidate: Review the stock marketing using a stock screener or other methods to find a potentially undervalued stock. It could be a well-known company trading below its market value or a lesser-known business you believe to be an undiscovered gem.
- 2.
Conduct a fundamental analysis: Fundamental analysis focuses on a company’s financial results to determine the stock’s actual value. This can be a time-consuming exercise, but it lies at the core of value investing. Common methods include using discounted cash flow models, analyzing a stock’s dividends, reviewing the company’s assets and liabilities and comparing the stock to industry peers. Most experienced value investors use a customized system where they weigh the importance of different analysis methods.
- 3.
Compare the underlying value to the market price: If you believe a stock is worth significantly more than the current market value, you’ve likely found a good value investment. If the stock price is near or above your estimated value, it’s likely not a good fit for a value investment portfolio.
Value stocks make up a significant portion of my investments. My long-term investment accounts are heavy in diverse index funds, with a large proportion of them made up of blue-chip value stocks.
Intrinsic value of stocks
Understanding a stock's intrinsic value is a key component of value investing. The intrinsic value is how much you believe a stock is worth based on your fundamental analysis.
Let’s say you use a discounted cash flow model and determine a company is worth $5 billion based on its financial performance and your projections for the next few years. You then look up the stock and find that it has 100 million shares outstanding.
To find the intrinsic value per share, divide the $5 billion enterprise value by the number of outstanding shares, or $5 billion/100 million. In this example, your target share price would be $50. You can then compare it to the stock’s market price to decide if it fits your value investment strategy.
Value investing at a glance
● Value investing focuses on the underlying value of the company
● If you believe a stock is undervalued, it could fit into a value investing portfolio
● There are no guarantees in the stock market and value investing has risks
● Value investing is a primary strategy employed by successful investors, including Warren Buffett
What is a value stock?
A value stock is a stock you believe is trading at a price below the value implied by the stock’s financial fundamentals. Investors use a variety of methods to identify value stocks.
If you’re early in the stock screening process, some common features of value stocks include:
- Low P/E ratio: The P/E ratio, or price-to-earnings ratio, allows you to compare companies using its stock price and earnings. Companies with proportionally higher earnings per share than others in the same industry are often undervalued.
- Low P/B ratio: Price to book ratio helps investors understand how a company’s stock price compares to its net assets. If a company holds many valuable assets and few liabilities, you may find that the company’s book value per share, or assets minus liabilities divided by the number of shares, is more valuable than the current price per share.
- High dividend yield: Dividend yield is the percentage of a stock’s price paid in yearly dividends. Stocks with high dividend yields may turn out to be value stocks. However, it’s always important to consider other factors as to why the dividend is high and if the company can continue paying dividends at such a high rate in the future.
At the end of the day, a company’s profitability and ability to maintain profits and growth in the future are critical factors in determining if a stock is a value stock. Evaluating the prospects of maintaining a competitive advantage is also crucial when seeking value stocks.
Value stocks vs growth stocks
Growth stocks are typically newer companies with a strong growth trend. Companies with new or in-demand technologies that are rapidly growing, bringing in new customers and growing revenue tend to fall into this category.
In many cases, value stocks are older and more established companies that may grow slowly but produce reliable profits and cash flows. Examples of industries with many value stocks include telecommunications and consumer goods. Industries with many growth stocks include technology, healthcare and finance.
In some ways, growth stocks may be riskier than value stocks, as it often has a shorter track record of success, and a slowdown in growth can lead to a significant drop in stock price.
Who should try value investing?
Value investing is appropriate for a wide range of investors. It’s one of the lowest-risk methods of choosing single stocks and index funds of value stocks, and it can form a core pillar of your investment portfolio. Value stocks and funds are particularly suitable for long-term investment goals, such as retirement.
If you’re new to investing, midway through your career or nearing retirement, there’s a good chance value investments could make sense for your unique financial goals and needs.
Example of value investing
When analyzing a potential value stock, it’s essential to consider the company’s financial performance, not stock price trends. Let's examine a hypothetical company, TechValue Inc., as an example of finding a value stock.
1. Assess Financial Health
First, review TechValue's financial statements. The company has:
- A strong balance sheet with $500 million in cash and only $100 million in debt
- Consistent free cash flow growth over the past five years
- A healthy profit margin of 15%
These factors indicate financial stability and efficient operations.
2. Calculate intrinsic value
Using a discounted cash flow (DCF) model, we estimate TechValue's intrinsic value at $50 per share. The current market price is $35, suggesting a potential undervaluation.
3. Examine valuation ratios
TechValue's key ratios compared to industry averages:
- P/E ratio: 12 (industry average: 18)
- P/B ratio: 1.5 (industry average: 2.2)
- EV/EBITDA: 8 (industry average: 11)
These lower-than-average ratios further support our theory that it’s an undervalued stock.
Based on the data from this analysis, TechValue would be a good candidate for a value stock investment.
How risky is value investing?
All stock market investments come with some risk. However, value investing is one of the less risky investment methods compared to other common stock strategies.
For example, investing in speculative growth stocks may produce outsized returns, but there’s also a higher risk of those stocks failing to meet expectations and becoming an investment loss. Similarly, investments based on technical analysis or the trends in stock prices over time can also add more risk to a portfolio.
When deciding whether to pursue value investing or any other investment strategy, it’s important to evaluate the risks involved and determine whether the potential risks and returns align with your investment goals.
How well do value stocks perform?
If you pick the right value stocks, you may experience substantial investment returns. But on average, if you look at value stocks compared to the market, you’ll see less dramatic differences in returns.
According to an analysis by Dimensional Fund Advisors, value stocks outperform the S&P 500 by an average of 4.4% annually. Some years are better and some are worse for value stocks. But in the long run, it's better than the typical stock.
Pros and cons of value investing
Pros
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Investment approach based on a company’s financial performance
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Historically better than the market average
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Less risk than many other investment strategies
Cons
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No guarantees of investment performance
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May underperform during sustained bull markets
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Still some risk of losses
FAQs
Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time.
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