Value investing is an investing method that involves finding equities that are undervalued even in a bull market. The process includes many assumptions and calculations about a company’s future performance compared to its share price now.
Value investors consider a stock undervalued if its price is lower than its intrinsic value. If the stock’s price is more than its intrinsic value, it is overvalued. Value investors believe that a company’s share price does not justify its long-term fundamentals, as prices depend significantly on market behaviour. Benjamin Graham was the pioneer of the method of value investing. When he lost his entire investment portfolio to the market crash of 1929, he developed a system to arrive at a stock’s intrinsic value, instead of considering its current market price.
How Does Value Investing Work?
The underlying principle of value investing is to buy stocks when they are undervalued and sell when they reach their intrinsic value or cross it. Investors consider this a long-term strategy. Value investors look for companies with long-term potential for growth but temporary downtrends in their prices owing to market biases.
How Do Investors Determine Intrinsic Value?
Value investors consider multiple parameters to determine a company’s intrinsic value, such as its financial history, business model, cash flows and revenues over the years, profits, and future profitability. They may also look for reasons why the company has been undervalued. They investigate to know if the company has the necessary financial and organisational capability to overcome its undervaluation. You can look into some qualitative factors such as the following to know whether a company’s stocks are undervalued.
- The company’s involvement in a financial scam
- The company’s credit rating indicates its debt clearing capacity
- Profit or loss amid the previous market recession
What Are Stock Metrics?
Investors use stock metrics to analyse, compare, and track stocks’ performance. Both value investors and analysts use them. You can use a variety of stock metrics while choosing an investment strategy.
Price-to-Earnings Ratio
The price-to-earnings ratio or P/E ratio helps investors in determining the stock’s market value compared to its earnings. To calculate this ratio, you need to divide the company’s current market capitalization and divide that value by its annual earnings.
Calculating this ratio can benefit you in understanding how cheap or expensive the stock is. A high P/E ratio means that the stock is currently expensive or overvalued relative to earnings. A low P/E ratio means that the stock is currently undervalued with respect to its earnings.
The metric can also tell you about the premium investors are willing to pay for the company’s earnings. The P/E ratio can be an effective way to compare two stocks in the same industry. A lower P/E ratio stock costs you less per share for the same financial performance than a higher P/E ratio stock. But, you cannot compare two stocks from different industries using this metric.
Price-to-Sales Ratio
You can calculate a company’s price-to-sales ratio by dividing its market capitalization by its annual sales. This metric is useful to compare those companies that you cannot judge solely on their earnings. Some companies that register high sales growth may register negative earnings. This ratio helps you assess if such companies are worth investing in.
You can find a company’s market capitalization by multiplying its current share price with its number of outstanding shares. Some investors also prefer including debt when they calculate the price-to-sales ratio. Including debt while calculating a company’s market capitalization can give you a more accurate picture. Doing so is helpful as a company may have derived its high sales owing to its massive debt. Another company’s stock may have a lower sales figure but it is debt-free.
Price-to-Book Ratio
Investors use the price-to-book ratio or P/B ratio to compare a company’s market valuation to its book value. You can calculate the ratio by using the following formula.
P/B = Market Price per Share / Book Value per Share
You can determine a stock’s book value by dividing its net value (total assets – total liabilities) by its number of outstanding shares. It is a more conservative metric of a company’s value, while the market price is the price investors in the market are willing to pay to purchase the stock depending on its future earnings.
A lower P/B ratio indicates that the stock is undervalued. A company with a P/B ratio of 0.5 is appealing to a value investor, as it indicates that the stock’s market value is half of its stated book value. But, a low P/B ratio can also mean that something is wrong with the company fundamentally.
Debt-to-Equity Ratio
This ratio tells you how a company finances its assets. You can calculate a company’s debt-to-equity ratio or D/E ratio by dividing its total liabilities by its total shareholder equity. You can find the information to calculate the ratio in the company’s balance sheet.
A lower D/E ratio indicates that the company employs a lower amount of debt to finance its assets against shareholders’ equity. A higher value for this metric means that the company depends more on debt compared to equity for financing.
Different industries have different debt-to-equity ratio standards. You cannot call a company badly managed just because its D/E ratio is poor. Companies often use debt to expand their operations and create extra income streams. Industries that invest a lot in fixed assets, such as construction and auto industries, usually have higher D/E ratios than companies in other industries.
Free Cash Flow
Free cash flow (FCF) is the cash that a company produces through its operations, net of its cost of expenditure. In other words, this value indicates the cash a company has after it has paid for its capital expenditure and operating expenses. The free cash flow of a company indicates its efficiency in generating cash. It helps you determine if a company has enough cash to reward its shareholders through share buybacks and dividends.
Price/Earnings-to-Growth Ratio
You can derive a stock’s price/earnings-to-growth ratio or PEG ratio by dividing its P/E ratio by its earnings growth rate for a specific period. Let us look at the formula to calculate the same.
PEG Ratio = (Price/EPS)/EPS growth
Here, EPS stands for the company’s earnings per share.
You can determine whether a stock is cheap or expensive by evaluating its current earnings and growth rate. You can use one-year, three-year, or five-year growth rates. This metric is helpful because it is hard to compare two companies in the same industry but at different stages, using only the P/E ratio. As you consider their future earnings as well, you can compare them better with the PEG ratio.
Profit Margin Ratio
A company’s profit margin ratio is the ratio that you get by dividing its profit by its revenue. Value investors can use this metric to determine how efficiently a company converts its sales into net income. As an investor, it is important to know that the company’s profits are high enough to give dividends. A low-profit margin indicates that the company’s expenses are high.
EV/EBITDA Ratio
The EV/EBITDA ratio is a commonly used valuation tool that investors use to compare a company’s value, including debt, to its cash earnings less non-cash expenses. To calculate a company’s enterprise value (EV), you need to determine its market capitalization. The product of its current market price of a single share and its outstanding shares gives you its market capitalization. You need to then add the company’s short-term and long-term debt to this value. From the resulting sum, subtract the company’s cash and cash equivalents to get its enterprise value. Some investors consider EV a better metric to analyse a company’s value than its market capitalization as it also considers the company’s debt.
Now, calculate the EBITDA. It stands for earnings before interest, tax, depreciation, and amortisation. A simple method to calculate EBITDA is to start with the company’s operating profit or earnings before interest and taxes (EBIT). You need to add back depreciation and amortisation, which you can find in the company’s cash flow statement, to get EBITDA. Divide EV by EBITDA to get EV/EBITDA. A lower EV/EBITDA ratio indicates a cheaper valuation.
Advantages of Value Investing
Risk Minimization
Usually, people associate investing in equities with high risk as their growth or decline depends on market movements. Value investors aim to mitigate risk by purchasing undervalued stocks with significant potential for growth in the future. When these stocks reach their intrinsic value or go higher, value investors earn significant capital gains. Value investors use margin of safety to minimise their risk. This means buying a share when its price is lower than a specific limit.
Substantial Returns
Value investing can offer you significant returns in the long term. This happens as investors use a margin of safety. For instance, you purchase a company’s shares at INR 70 per share when their intrinsic value is INR 100 per share. You will earn INR 30 per share when you sell these shares when the stock reaches its intrinsic value. You can earn even more if share prices go higher.
Disadvantages of Value Investing
Long-term Investment Option
Value investing compels you to remain invested for longer periods, as it does not usually provide higher returns in the short term. This is one of the major disadvantages of value investing.
Time Consuming
This investment method needs a lot of your time as it involves looking for undervalued companies by using many quantitative and qualitative fields. You need to spend a lot of time reading about companies, analysing them, and calculating different metrics to select stocks to invest in.
P2P Lending – An Alternative
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Conclusion
You must remember that even when you are extremely careful about choosing your stocks and have spent a lot of time analysing them, the risk is inevitable. You should limit your investment in equities or any investment opportunity to the amount that you can comfortably afford. You should not overburden your budget to invest. In this way, you also limit your risk exposure.