Value Stocks
Undervalued companies with strong fundamentals expected to grow; often trade at lower price-to-earnings ratios.
Value stocks refer to company shares trading below their intrinsic price. Meaning the share price is trading below its actual price and is undervalued.
Investors who find and invest in these value stocks are known as value investors, and the investing method is known as value investing.
These types of undervalued stocks are primarily found in mature and well-established companies that may have gone unnoticed by investors and the markets. Or it may have had some temporary setback that brought down the stock price more than its intrinsic value.
Other factors can result in the undervaluation of stocks, like the business cycle, economic recession, controversies, and market inefficiency.
To find these undervalued stocks, investors use something known as fundamental analysis to understand different factors of the company, like its financial statements and management quality, alongside macro and microeconomic factors, industry trends, and competition.
Investors use many metrics in fundamental analysis to find an undervalued company—for example, the P/E ratio, EPS, P/B ratio, and dividend yield.
Key Takeaways
- Value stocks are undervalued shares trading below their intrinsic price, and investors who seek them are known as value investors.
- Fundamental analysis is used to find undervalued stocks by examining financial statements, industry trends, and macroeconomic factors.
- Key investing metrics for value stocks include P/E ratio, P/B ratio, dividend yield, and free cash flow.
- Undervaluation can result from market sentiment, business cycles, company-specific factors, or economic recessions.
- Value investing involves seeking a margin of safety, a buffer between a stock's intrinsic value and its market price, to manage risk and earn returns over time
Investing Metrics in Value Stocks
There are many methods of investing in value stocks; it is up to the investor to decide which method works best in line with his investment objective.
Some well-known investing metrics are:
1. Price-to-Earning ratio or P/E Ratio
It is one of the most widely used investing metrics investors use for their investment objectives.
It compares a company's stock price to its Earning per share(EPS); this gives an idea of how much the market is willing to pay for a company’s stock in comparison to its earnings.
In most cases, a low P/E ratio indicates that a company’s stock is undervalued in the market. At the same time, a high P/E ratio suggests that the market is paying a premium for the stock.
So if a company has a P/E ratio of 10, this means that investors are willing to pay $10 for its stock to get $1 from its current earnings.
The formula for the Price-to-Earning ratio:
Share Price / Earnings Per Share*
*Earnings Per Share = (Net income - Preference Dividend) / Average Common Shares
Note
The P/E ratio is useful only when compared to the industry average and other companies in the same industry. This is because different industries have different acceptable P/E ratios. For example, the P/E ratio for a technology company is generally around 20.
2. Price-to-Book Ratio or P/B Ratio
Investors use the price-to-book ratio or P/B ratio to compare a company’s stock price with its book value. It shows how much the investors are willing to pay for a company’s net assets.
Book Value is the value of a company’s leftover assets that belong to the shareholders after all the debts are paid off.
Note
A high P/B means the market is willing to pay a premium for a company’s asset, and a low P/B means the market is undervaluing the stock compared to its net asset or book value.
For example, the Price-to-Book ratio of Tesla is around 14, which means the market is willing to pay $14 for every $1 of book value that Tesla holds.
The formula for the Price-to-book ratio is:
Market Price per Share / Book Value per Share*
*Book Value per Share = (Total Assets - Intangible Assets - Total Liabilities) / Number of Outstanding Shares
3. Dividend Yield
The dividend yield shows the annual dividend paid by a company compared to its share price.
Higher dividend yield relative to a company's stock price may indicate undervaluation of the stock and vice versa.
It shows the earning potential of the share in relation to its price.
Note
It is important to know that there may be other reasons for this high yield, and an investor should also look for other metrics to confirm whether a stock is truly undervalued.
The formula for dividend yield is as follows:
Annual Dividend per Share/ Price per Share
Free cash flow, or FCF, is also one of the most popular investment metrics used by investors to assess a company's financial health.
It shows how much cash a business generates from its operation after deducting capital expenditures which it can use for debt repayment, reinvestment in the business, or it can be distributed to investors.
The formula for Free Cash Flow is as follows:
Operating Cash Flow - Capital Expenditure or CAPEX
A positive cash flow indicates that the company is generating surplus cash, which it can use for various purposes and generally shows that its financial health is good.
Reasons For Undervaluing a Stock
Many factors affect the price of a stock; these can be internal as well as external factors. Some of these factors that can lead to an undervaluation of stock are:
1. Market Sentiment or Market Inefficiency
Market Sentiment or market inefficiency is one of the biggest reasons for undervaluation. A company's fundamentals can be strong, but if the market is pessimistic about the future, the stocks will underperform relative to their true value.
Sometimes there can be a line sport in a market, and investors may not recognize certain stocks; this line sport can lead to inefficiency in price discovery which will ultimately result in an undervaluation.
2. Business Cycle
Some businesses operate in a cycle where their revenue goes up in a certain season and down in another.
For example, manufacturers of AC will see an uptick in their stock in the summer season, and in winter, due to low sales there, the stock may go undervalued.
Note
The fundamentals of the company may not change, but due to temporary slowdown in sales can lead to a decrease in stock price which can ultimately make the stock undervalued.
3. Company-Specific Factors
Sometimes someone in a company's higher management can be involved in some sort of scandal. This likely will not affect the fundamentals of a company, but the stock price can be affected due to negative press.
Any one-time setbacks like a product recall, pending lawsuits, or regulatory concerns may also lead to a fall in share price below its intrinsic value.
These factors can create a bad image for a company or create an uncertain environment for the future.
Note
If the price falls below a certain range, it can be worth the risk, as there is always a chance good management will be able to turn the tides around.
4. Market Recessions
Market or economic recessions are the best time to find undervalued companies. During a recession, most people will try to get their money out of the market in a panic, and an economic downturn creates an uncertain environment for the future.
But if an investor is rational and plays a long game, they can make massive gains on their investment if they find the right companies to invest in during a market panic. Famous value investing Warren Buffett invested in Goldman Sachs during the 2008 financial crisis.
He invested in Goldman Sachs for $5 Billion worth of preferred stock paying a 10% annual dividend, and the ability to buy 43.5 million worth of Goldman Sachs shares for $115 each at any point in the following five years.
In the end, Berkshire Hathaway Buffett's investing company made around $3 Billion in profit from its Goldman Sachs deal. Just because he realized that due to market panic, Goldman’s shares were massively undervalued, and the bank's fundamentals were very strong.
Value Investing And Margin Of Safety
Value investing is a type of investing method in which an investor seeks out undervalued companies to invest in.
In Value investing, investors take advantage of market inefficiency, which leads to the undervaluation of a company's share.
While looking at a company's values, a value investor always looks for a reasonable margin of safety where there is some buffer to absorb losses even if the investment goes bad.
The Margin of Safety is an important principle of managing risk in value investing. It is the difference between the fundamental value and the current market price of the company's shares.
An example to understand how the margin of safety works:
Let us say an investor is looking at Intel corporation financials; after all the fundamentals and market analysis, the intrinsic value of the company came to be $50 per share, and the current market price at which the share is trading is $30.
So the margin of safety for investing in Intel will be $50 - $30 = $20. This $20 is the discount at which the share is trading below its intrinsic value and acts as a shock absorber for future factors.
The margin of safety gives an investor room for error and downside protection while giving an opportunity to earn a return on the investment as the market corrects itself and hits that $50 per share value that the company has.
Value stocks are the shares trading below the company's fundamental or intrinsic value.
Growth stocks are the shares trading over the company's actual value. The investors are paying this premium expecting high future growth.
Value stocks are mostly found in well-established companies with strong fundamentals and good asset quality, while growth stocks are mostly found in new start-ups like companies that have strong growth potential.
Investors who use value investing are known as value investors. They take advantage of market inefficiencies to find undervalued companies. And make a profit when the company's share price and intrinsic value match.
Warren Buffett is regarded as the biggest value investor of our time. Buffett worked with Benjamin Graham in his early years, who is also known as the father of value investing. He described Graham to be the second-most influential person in his life after his father.
Benjamin Graham's book The Intelligent Investor is known to be the most influential book in the world of value investing.
Every investor has a way of identifying value stocks. The company's intrinsic value will differ from investor to investor. One has to find an investing strategy that works for them.
But there are common tools that all value investors use to identify undervalued stocks. Examples of these tools are; the P/E ratio, free cash flow, the P/B ratio, Dividend yield, and many more.
Anyone who wants to find value stocks can use these tools with other metrics affecting the market to fulfill their investment objective.
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