Value investing means a certain philosophy that defines the way an investor approaches stock selection. It is not about buying cheap goods and outdated models, or buying undervalued stocks; it is about finding stocks that the market has not properly valued. The goal is to find a stock that is worth more than what the current price reflects.
Key Takeaways
Value investing is about finding stocks that are worth more than what the current price reflects. Value investors are concerned with the fundamentals of the company, such as earnings growth, profitability, cash flow, and book value. When analyzing investments, value investors look at the price-to-earnings (P/E) ratio, price-to-earnings growth (PEG) ratio, debt-to-equity (D/E) ratio, price-to-book (P/B) ratio, and earnings growth. To find the true or fair value of a stock, use sources such as Morningstar (which charges a fee) or Reuters (which is free).
Value Investors
A value investor, perhaps more than any other type of investor, is concerned with the business and its fundamentals – such as earnings growth, profitability, cash flow, and book value – more than other influences on the stock price.
Value investors are also long-term investors who buy and hold stocks. If the fundamentals are sound, but the stock price is below its intrinsic value, the value investor knows this is a potential investment candidate because the market has mispriced the stock. When the market corrects this error, the stock price should rise.
The Market is Right
It is not uncommon for the market to be correct, and the stock may be beaten down for any number of fundamentally valid reasons, such as declining earnings, decreasing revenue, or a fundamental change in the market or product line.
Take a pharmaceutical company as an example. If they have a leading product that is pulled from the market by the government, that fundamentally changes the company. On the other hand, other pharmaceutical companies may also see their stock prices decline, even though they are not part of the recall. This may make those companies worth considering by the value investor.
Principles of Value Investing
When it comes to selecting investments, value investors should come up with a formula that works for them, but it should at least include analysis of the following metrics:
Price-to-earnings (P/E) ratio
Price-to-earnings growth (PEG) ratio
Debt-to-equity (D/E) ratio
Price-to-book (P/B) ratio
In addition to these metrics, value investors look for strong earnings growth over a long period – generally 6-8% over 7-10 years – and do not pay more than 60-70% of the intrinsic value of the stock for each share.
Intrinsic Value
Current accounting standards are sufficient for measuring buildings and equipment (book value). However, as our economy shifts towards more technology and knowledge, many of these intellectual assets do not show up in financial statements. Value investors recognize that the target company for investment has much greater value as an ongoing business than its tangible assets. In many cases, it is the intangible items – patents, trademarks, research and development, brand recognition – that drive future growth expectations, not fixed assets.
Finding the intrinsic value of a stock is a complex process, and there are many ways to arrive at the number. Fortunately, there are many places you can go online to find the number. MorningStar.com calculates the number, referred to as “fair value,” on its site, but you need to be a member to access it. Another good source is Reuters, which is free.
Regardless of how you arrive at intrinsic or fair value, give yourself a margin of error with the idea that if your calculations are wrong, you might pay too much. If you used one of the services mentioned above or another source to find intrinsic value, check to see if they have actually added a margin of error. For example, if you believe the intrinsic value of the stock is $40 per share, give yourself a safe margin and lower your target to $36 per share.
Source:
https://www.thebalancemoney.com/understanding-value-investing-3141111
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