With the high rate of investment in the stock market in India, it is worth knowing all about stocks and related concepts. More importantly, there exist different types of stocks in the market, and serious investors may gain a wealth of knowledge (and returns) if they understand these types. One of the types of stocks is a value stock. A value stock is a stock of a company that is under-valued in any market.
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What are Value Stocks?
Many investors are of the opinion that the market potentially over reacts to certain news. This may result in fluctuations in a stock’s price. Such fluctuations, when making the stock appear low in value, may not precisely show the health of the fundamentals of the company in question. Consequently, such stocks that are presently trading at prices lower than the intrinsic value of the companies they represent, are called value stocks. Value investing or the investment in value stocks is a common approach among investors and is based on a simple premise – the market will ultimately acknowledge the real potential of such stocks and the price will recover pace and potentially yield positive returns.
Learn How Value Stocks Work
If you are trying to grasp value stocks meaning, learning how value stocks work may be a good place to start.
Value investing is essentially based on the simple idea of buying and selling. Think of a similar concept in terms of a product. If the real value of a given product is known, you can buy the product at a discount (cheap rate) and sell it later at a higher price value. In a similar way, in value investing with stocks, investors can identify low-value stocks of fundamentally strong companies and buy them at a low price. The investor then holds the stock till the time the market realises its true value. This is the time that the price of the stock will rise and the investor has the potential to make a profit.
For example, assume you want to buy a television like you want to buy a value stock. India has many occasions when you can buy a TV on sale, like at Diwali. Buying it on sale or at full price won’t make any difference to you in terms of the size of the screen or any other feature of the television. Similarly, if you buy stocks at prices lower than their intrinsic value, this is like buying stocks at discounted prices. Nonetheless, unlike products on sale, low-price stocks are not advertised, and investors have to sift through stocks to find them. With analysis and research, you will have to identify stocks of fundamentally robust companies that are trading at low prices.
What is a Value Stock? Know the Features
Now you know that value stocks are undervalued. They are typically cheaper relative to other stocks like growth stocks. A key characteristic of value investing in these stocks is the clear high dividend yield (as this is an underperforming security) with a low price to earnings (PE) ratio. Additional relevant features of value stocks include less fluctuations in price, at the times of market highs as well as market lows.
How Do You Identify a Value Stock?
Once you know the value stock definition, you may grasp how to identify a value stock. Value investors are those individuals who buy stocks that are undervalued, trading at a discount. If you wish to know that a share is trading at a discount, you first have to clearly identify the stock company’s (or the stock’s) intrinsic value. What is intrinsic value? Simply put, it is a blend of the financial structure, revenues, cash flows, and profit of a company. Intrinsic value also includes certain basic factors like the business model, brand, market structure, among others. If you want to adequately identify value stocks, you must rely on intrinsic value factors and these measures of a company (and its stock) must be considered:
- P/B Ratio (Price-to-book ratio)
The Price to book ratio is basically calculated by dividing the stock price of the company by its book value per share. The book value only means the total assets with any liabilities subtracted. Low P/B ratios are potentially indicative of stocks that are undervalued, and may be of use when searching for a value stock.
- P/E Ratio (Price-to-earnings ratio)
Price to earnings ratio is essentially calculated by dividing the stock price of the company by its earnings per share (EPS). The P/E ratio helps to understand the relationship between the market stock price and its real earnings as per the books. A low P/E ratio may imply that the stock is undervalued and consequently has a chance of future increase in its share price.
- P/S Ratio (Price-to-sales ratio)
The Price to sales ratio is easily calculated by dividing the company’s market capitalisation by the company’s revenue (total sales). Market capitalisation refers to the total outstanding shares multiplied by the market price per share. A low P/S ratio could be considered a positive buy because the stock is an undervalued stock.
- Free Cash Flow
Free cash flow refers to the net cash that the company generates after subtracting all the capital and operating expenditure. In case the company possesses free cash flows, it will have capital to make future investments, declare dividends, pay off debts, etc.
Also Read: Current Ratio: Definition, Formula, Example
Other Factors in Value Stock Determination
In determining a promising value stock, there are other metrics besides the ones mentioned. While making a list of potentially prospective value stocks to invest in, investors must appropriately ensure that they have grasped the company’s financials, product offerings, competitors, and the corporate governance company track record. These are all representative of the fundamental health of the business. After scrutinising all these aspects, investors can make decisions about whether a stock is really a value stock potentially capable of yielding future returns.
Also Read: Bracket Order in Stock Market
Why Stock Valuation Matters
In ideal circumstances, the share price of any stock should equal its intrinsic value. Nonetheless, this may not be true in the best of situations, especially in the stock market where you may find a value stock. From a long-run perspective, the price of any particular stock could be nearly equal to its value, but this may not occur in the short term. This happens due to several reasons. The reasons may include anything from macroeconomic disruptions to the cyclical nature of the business sector the company belongs to.
Value investors estimate that the market will eventually realise the stock’s mispricing and will go ahead and correct it. This is the reason why serious investors partake in value investing by investing in fundamentally solid stocks that may trade at low prices. Consequently, finding out the intrinsic value of a stock is the main benchmark to decide if stocks are cheap to buy or overpriced to be sold. Intrinsic value acts as a reference point, without which it may not be possible to undertake the strategy of “buy low and sell high”.
Read More: Buy and Hold strategy in the Stock Market
Final Words – The Value in Value Stocks
You must have gauged by now that value stocks and value investing are long-term channels of investment. While considering value stock meaning, and deciding on what is a potential value stock, you have to assess the stock’s intrinsic value. Your decisions are likely to be based on your own research into the stock, your goals, and your appetite for risk. It is imperative to study the industry that the company belongs to as well as its potential future in the industry, apart from company fundamentals. Above all, you should note that value investing is for the long term and hence, requires patience.
*Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only*
