Looking to begin investing in the stock market? One popular approach many people take is to select companies that show major potential for growth. Often, these are smaller upcoming companies. Putting your money into these stocks might just see your investment grow significantly if that company’s stock price skyrockets.
But let’s say you’re thinking long-term and aiming to perhaps build a nest egg for a big future goal. Then, the value investing strategy might be just what you need. Wondering what value investing is? In this article, we’ll break down the definition of value investing and dive into how it works.
What is Value Investing?
The meaning of value investing is quite straightforward. The strategy centres on pinpointing and investing in stocks from companies that are currently undervalued. An undervalued stock is priced lower than its actual worth or intrinsic value. The goal is to buy these stocks at a low price, hold onto them for a few years, and then potentially profit when their price eventually rises to reflect their true value.
In essence, these stocks belong to companies overlooked by the market. As time passes and the broader investor community recognizes the true value of these firms, the demand for their stocks rises. Consequently, the price of such stocks is expected to climb, aligning more closely with their intrinsic values.
Key Metrics Used to Identify the Intrinsic Value
To follow a successful value investing strategy, it is crucial to identify the intrinsic value of a stock. Only then can you compare the value with the stock’s market price and make a judgement about whether or not the stock is undervalued. The following metrics can help identify the intrinsic value of a company’s shares.
- Price-to-Earnings Ratio (P/E Ratio)
This ratio is a comparison of the prevailing market price of a company’s shares and the earnings per share (EPS). A high P/E ratio may indicate that the stock is potentially overvalued, while a low P/E ratio may be a sign that the stock is undervalued. So, stocks with low P/E ratios may be suitable choices for your portfolio if you are following the value investing strategy.
- Price-to-Book Ratio (P/B Ratio)
The P/B ratio is a comparison of the book value of a company’s shares and the market price per share. A higher P/B ratio indicates that the company is overvalued, but a lower P/B ratio — especially if it is below 1 — could indicate that the company is undervalued. It is these stocks that you need to focus on if you want to adopt the value investing strategy.
- Discounted Cash Flow
The discounted cash flow is the present value of future cash flows that a company can generate from its operations. These future cash flows are discounted at an appropriate and realistic interest rate. By computing the present value of future cash flows, you can arrive at the intrinsic value of a company’s shares and compare it with the prevailing market price.
- Earnings Before Interest and Taxes (EBIT)
This metric helps you identify the cash flow of a company before the effect of interest and taxes. It is a useful factor to track before it helps you assess how a company may perform in the future. In other words, even if the company may be making losses initially, it could turn profitable if its organisational, financial and operational framework is intact.
- Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)
The EBITDA is also often used in combination with the EBIT to perform a more thorough fundamental analysis of a company and arrive at its intrinsic value.
Conclusion
In addition to the above quantitative factors, there are some qualitative aspects as well that you need to analyse to determine if a stock is undervalued. They include the company’s credit rating, its performance during a recessionary phase in the market and its credibility among its customers. These factors can give you some insights into whether or not the company’s value may appreciate or depreciate over time.
Ultimately, value investing is a strategy that can be extremely beneficial if you know when to use it and how to use it well. To get better at value investing, it is essential to learn the finer details of fundamental analysis, which focuses on the valuation of stocks.
