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Value investing is a long-term investment strategy that tries to find undervalued stocks. Here's how it works.
Best exemplified by the Oracle of Omaha himself, Warren Buffett, value investing is an investing strategy that tries to find value in the stock market.
What's in this guide?
- What is value investing?
- How does value investing work?
- Value investing vs growth investing
- Why would a stock be undervalued?
- How do I determine if a stock is undervalued?
- What are the risks of value investing?
- What are some value stocks?
- What type of investor does value investing suit?
- Frequently asked questions
What is value investing?
Value investing is a investing strategy that involves picking stocks or securities that are currently trading below their true or “intrinsic value”. It is based on the idea that markets are not necessarily completely rational, and that there are companies and stocks out there that are currently undervalued in relation to their fundamentals, and are therefore trading for less than their book value.
It’s a popular strategy for many large investment funds, including Warren Buffett’s Berkshire Hathaway, and uses a long-term, qualitative approach to investing. It’s often considered a contrarian strategy, as it involves finding companies that have been ignored by the market as whole, and avoiding stocks that are currently overhyped or dominating headlines.
Value investing is perhaps best summarized by Buffett himself, who says “it’s better to buy a great company at a fair price, than a fair company at a great price.”
How does value investing work?
In simple terms, value investing means finding companies on the stock market whose current share price is undervalued compared to the company’s actual value. An everyday analogy would be buying an item on sale, such as a fridge. The “fundamentals” of the fridge don’t change during a sale period, you’ll simply be paying less for the exact same thing.
The same idea can be applied to stocks. Stock prices change all the time, even if the underlying fundamentals of the company have not, and value investing is the strategy of identifying and buying stocks that are “cheap”, in anticipation of them rising once the rest of the market catches on.
Value investing vs growth investing
The opposite of value investing is generally referred to as growth investing. This is a strategy that involves investing in companies that are expected to grow more quickly, regardless of how the company’s fundamentals measure up to its share price.
An example would be investing in a new tech startup that may still be operating at a loss, but is poised to secure a large market share or dominate an emerging market.
During prolonged bull markets (and especially stock market bubbles), value investing has historically offer lower returns than growth investing, as investors are generally more interested in chasing growth stocks. However, value investing has often outperformed the market following stock market crashes, or in the period following a stock bubble bursting.
Why would a stock be undervalued?
There’s a number of reasons a particular stock might be undervalued, including the following:
- Stock market crashes. Whenever there’s a wider stock market crash, like what happened in March 2020, the share price of most companies drops. This is generally a result of investors getting scared, or losing faith in the market as a whole, and does not necessarily reflect how a company is performing in real life. As a result, companies with strong fundamentals may see their share price drop along with the rest of the market, and lead to them being undervalued.
- General market behaviour. If the price of a certain share declines, some investors may panic and see that as a reason to sell, leading to the price dropping further. This is called a selloff, and can lead to situations where a company’s share price plummets without real justification. Such stocks can often end up undervalued, and may rebound once the market calms down.
- Untrendy companies or industries. The stock market features companies from a huge range of industries, and it’s no surprise that some are more popular with investors than others. Industries such as tech and green energy often dominate headlines, and this can lead to investors ignoring undervalued companies with strong fundamentals in “boring” industries, in favour of chasing the next big tech stock.
How do I determine if a stock is undervalued?
There are a couple of popular measures investors use to determine the “intrinsic value” of a stock or company, including:
- Price-to-book (P/B) ratio (or “book value”): This is the value of a company’s assets (minus debts) compared to its current stock price. A company may be considered undervalued if its stock price is lower than the total value of its assets (i.e. it has a P/B ratio under 1).
- Price-to-earnings ratio (P/E): This is the ratio of a company’s revenue to its current share price and is calculated by dividing the stock price by the earnings per share (EPS).
- Free cash flow: Free cash flow is the amount of money a company has once you’ve subtracted all costs and expenditures, such as operating expenses and business purchases. Companies with free cash flow are in a better position to grow their business.
What are the risks of value investing?
While value investing is generally considered a relatively conservative approach to investing, it’s not without its risks. It requires you to have a high level of understanding of how to analyze a company’s fundamentals, and relies on you being able to access accurate and up-to-date information on a company’s finances and operations.
If your analysis is incorrect, or you’ve applied the wrong metrics to measure a company’s intrinsic value, you may actually end up overpaying for the stock. Worse still, even if your analysis of a company is “correct”, and it is undervalued in relation to its stock price, the wider market will still need to agree with this sentiment, otherwise the share price is unlikely to go up.
Value investing means you’re effectively betting against the market, and this is always a somewhat risky approach. You may find that your value investment stays stagnant for an extended period, or even declines in value, and this means you’ll be missing out on the potential gains that may be on offer elsewhere.
As the financial analyst A. Gary Shilling once said, “the stock market can remain irrational a lot longer than you can remain solvent.”
What are some value stocks?
Value stocks are those that are trading at a lower price compared to its underlying fundamentals, such as its P/B or P/E ratio. Value stocks are often found in established, but unexciting, industries such as energy, construction or finance. Examples of value stocks may include large financial corporations such as JPMorgan Chase or Lloyds, which both have lower P/E ratios compared to the average S&P 500 or FTSE-100 company respectively.
What type of investor does value investing suit?
In order to be a successful value investor, it’s likely you’ll need to be patient, analytical and composed. Value investing involves lots of research and critical thinking, and is inherently a long-term investing strategy. This means it won’t suit emotional or restless investors, or those who don’t have the time or resources to work out if a company is undervalued.
Value investing for dummies
If you don’t think you have the skills, or time, to correctly analyze fundamentals and identify undervalued stocks, you can still practice a form of value investing by either following the trades of well-known value investors, or invest in mutual funds or ETFs that explicitly follow a value investing strategy.
Frequently asked questions
All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.
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