What Is Value Investing

What is value investing? If you are an investor who is curious to know about how exactly value investing works, here’s the answer. In this blog, we delve deep into what value investing, key concepts in value investing, techniques, advantages, disadvantages, and much more.

What is Value Investing?

In simple terms, value investing means purchasing shares or other assets that are trading below their intrinsic value. Here the main objective is to identify assets that the market has mispriced. Now you might be wondering what the term ‘mispriced’ is all about. It is nothing but those shares or assets whose current prices do not reflect their actual worth based on the company’s fundamentals. It was an American economist by the name Benjamin Graham who pioneered the concept of value investing in the 1920s. Due to this reason, he is referred to as the “Father of Value Investing”.

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Three key concepts in value investing

Before getting deeper into how value investing works, you need to understand the 3 main concepts.

1. Intrinsic Value

Intrinsic value is nothing but the true value of a stock. It is calculated by analysing factors such as earnings, dividends, growth prospects and overall financial health.

2. Undervaluation

A stock is considered undervalued when it trades at a price lower than its intrinsic value. These are excellent opportunities for value investors to purchase the stock at a discounted price.

3. Overvaluation

When the market price of a stock is higher than its intrinsic value, it is considered to be overvalued. It is an indication for value investors that time has come to sell the stock.

How does value investing work?

Superexcited to know how value investing works? It is done by leveraging the difference between a stock’s present market price and its intrinsic value.

The technique used by value investors to calculate the intrinsic value of a stock is called fundamental analysis. For eg. If you are a value investor, you have to examine a company’s financial statements, assess its management, and take into consideration the broader economic factors. In case the stock’s market price is way lower than its intrinsic value, it signals that the particular stock is a potential investment. 

The example below will help you easily understand this concept.

Assume that a stock is trading at Rs.50. However, after conducting a detailed analysis, you come to know that the stock’s intrinsic value is somewhere around Rs.70. Hence, you can consider that stock to be undervalued. 

To keep it simple, here the whole idea is to purchase undervalued stocks and hold them till the time their prices increase to reflect their true value.

Four techniques to calculate intrinsic value

As a value investor, you can use the following 4 techniques to derive intrinsic value.

1. Price-to-earnings ratio (P/E):

In this ratio, a firm’s share price is compared with its earnings per share (EPS). If the P/E ratio is low, it shows that the stock is undervalued relative to its earnings.

2. Price-to-book ratio (P/B):

Here the comparison is made between a company’s stock price to its book value. In simple terms, the company’s assets minus its liabilities. If the P/B ratio is below 1.0, it is an indication that the stock might be undervalued.

3. Discounted cash flow analysis (DCF):

Under the DCF method, the present value of a company’s expected future cash flows, adjusted for inflation and other factors is calculated. It helps value investors to find out whether the current stock price reflects the company’s potential.

4. Earnings before interest, taxes, depreciation, and amortisation (EBITDA):

A major benefit of the metric EBITDA is that it helps evaluate a company’s operating performance. As non-operating expenses are excluded, it offers a clear idea about a company’s earning potential.

Advantages of value investing

1. Risk minimisation

Generally investing in equity shares is considered to be highly risky due to market fluctuations. However, in the case of value investing, investors mitigate that risk by buying stocks that are undervalued. With the passage of time, these stocks would touch their intrinsic value or maybe even higher thus giving them substantial capital gains. 

Value investors use margin of safety to reduce the associate risk. It means they buy a share when the prices are lower than a particular limit. Thus even if the stock does not perform as expected, it will help limit potential losses.

2. Potential for substantial returns

Since value investors purchase stocks at discounted prices, it comes with substantial upside potential when the stock prices shoot up to touch or go beyond its intrinsic value. This leads to significant gains in the long run.

3. Focus on solid businesses

Value investors generally invest in well-established companies that are fundamentally strong. Due to this reason, this strategy is less speculative in comparison to other investment methods.

Disadvantages of value investing

1. Research consumes time

Value investing demands a detailed analysis of financial statements, business models, and market trends. This consumes a lot of time and may require significant effort to determine undervalued stocks.

2. Requires long-term commitment

A major disadvantage of value investing is that it does not provide higher returns in the short-term. Thus, investors must be ready to lock their capital for a long period of time.

3. Risk of value traps

There are times when stocks may appear undervalued. However, in reality, they may be declining due to fundamental issues. Such ‘value traps’ may end up in low investment returns if the company does not recover.

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Strategies for value investing

A key strategy of value investing is to identify undervalued stocks by using metrics such as PE/PB ratios etc. mentioned above. It is pretty important to analyse a company thoroughly and determine its intrinsic value to make substantial profits and cut down risk.

One more approach is to find out companies that have assets that are not properly reflected in their balance sheet. An example of such assets is intellectual property, like patents. In the future, their value might increase due to market conditions thus causing stock prices to go up dramatically.

Key takeaways

• Value investing is a strategy of purchasing securities that appears to be underpriced in comparison to their intrinsic value.
• The 3 key concepts in value investing are intrinsic value, undervaluation and overvaluation.
• The 4 main techniques to calculate intrinsic value are Price-to-earnings ratio (P/E), Price-to-book ratio (P/B), Discounted cash flow analysis (DCF) and Earnings before interest, taxes, depreciation, and amortisation (EBITDA).
• The advantages of value investing are risk minimisation, potential for substantial returns and focus on solid businesses.
• The disadvantages of value investing are time-consuming research, long-term commitment required and risk of value traps.

Parting Words

Now you have a fair idea about value investing. However, it works best when there is an expert mentor to guide you in the stock market. Entri Finacademy, a trusted finance education platform, is offering all that and more since 2017. With a team of expert mentors and over 9 million students, Entri offers an altogether different experience to its students. Moreover, at Entri, you have the option to learn about stock markets in several regional languages, including Malayalam. To know more about Entri Finacademy’s stock market courses, click here.