Key Points
- It involves buying undervalued stocks and selling them when their price adjusts to their true value.
- Some consider growth to be part of value, so they are not opposing approaches.
- The term value investing was first used by Benjamin Graham and David Dodd, professors at Columbia Business School.
What is Value Investing?
Value investing is an investment strategy that involves buying stocks priced below their intrinsic value. In other words, value investing is a stock-picking technique that focuses on finding stocks trading for less than what they are truly worth.
When we talk about intrinsic value, we refer to how much a company should be worth based on its financial statements and growth potential—not its fluctuating market price.
Value Investing: How Does It Work?
Value investors are always on the lookout for bargains. They believe the market tends to overreact to news—whether positive or negative—causing stock prices to rise or fall more than they should.
They see these overreactions as opportunities to buy low and eventually sell at a profit when the market corrects itself to reflect the company’s true fundamentals.
Value investing is often considered a different approach from growth investing. However, it’s worth noting that some argue growth investing—targeting companies expected to grow faster than average—is not the opposite of value investing. They believe growth is simply one aspect of a company’s overall value.
The Philosophy of Value Investing
Value investors argue that although prices may be low now, they will eventually rise to reflect their intrinsic value—meaning the price should align with the true worth of the stock. To achieve this, investors must determine a stock’s intrinsic value independently of its market price.
Value investors believe intrinsic value can be assessed through a stock’s book value, determined by conducting a fundamental analysis of the company. This involves examining the firm’s financial statements (current or projected), discounting future earnings, or in some cases, discounting future dividends. The difference between intrinsic value and the stock’s market price is known as the margin of safety. The larger this margin when making an investment, the greater the potential profit.
Value investors look for companies with durable and stable competitive advantages, which is why their investment horizon is long-term. This is because the market may take time to adjust the stock’s price to its intrinsic value.
Aligned with behavioral finance, value investing recognizes that overreactions to negative news can lead to undervalued stock prices, causing the market price to deviate from the stock’s true worth.
Critics of Value Investing argue that low prices reflect underlying risks—if a stock is cheap, there may be a valid reason.
Value investors, in turn, criticize growth investing for the risk of future declines in high valuation multiples (such as P/E and P/B ratios). Additionally, growth investors face the risk that a company’s future earnings may fall short of expectations, as predicting future profits is inherently uncertain.
Sub-Styles of Value Investing
There are three main sub-styles of value investing. They are not mutually exclusive and are often used in combination, though each value investor may lean more toward one than the others:
- High Dividend Yield: Investors expect high dividend payouts to persist, providing strong returns.
- Low Valuation Multiples: Investors anticipate that stocks with low ratios (such as P/E and P/B) will appreciate as the economy improves, focusing on companies with undervalued metrics.
- Contrarian Investing: Investors bet on stocks they believe are temporarily undervalued due to market sentiment.
One way to practice value investing is through dedicated mutual funds or ETFs. To invest this way, you’ll need to purchase shares of the fund through a brokerage platform.
Origins of Value Investing
The term value investing was first used by Benjamin Graham and David Dodd, professors at Columbia Business School. In their 1934 book Security Analysis, Graham introduced the concept of the margin of safety.
The most famous book on this investment approach is The Intelligent Investor. In it, Graham advocates a defensive strategy, investing in companies trading below their book value to provide a margin of safety against potential market downturns.
Over time, this investment philosophy has grown steadily and continues to gain followers. Some of the most renowned practitioners of value investing include Warren Buffett and Francisco García Paramés.
How to Identify Undervalued Stocks
To succeed in value investing, you need to develop one crucial skill: the ability to identify stocks that are undervalued by the market. This means learning to look beyond the current stock price and understand a company’s true worth. Here’s a step-by-step guide on how to do it.
Fundamental Analysis: Understanding Financial Statements
Fundamental analysis is your primary tool for uncovering a company’s financial strength and growth potential. Start by familiarizing yourself with the three key financial statements:
- Income Statement: Shows how the company generates revenue and manages expenses.
- Balance Sheet: Provides a snapshot of the company’s financial health, including assets, liabilities, and shareholders’ equity.
- Cash Flow Statement: Reveals how the company generates and spends cash.
Learning to read and interpret these documents will help you assess whether a company is well-managed and has long-term growth potential.
Key Financial Ratios: P/E, P/B, ROE
Financial ratios offer a quick and effective way to compare companies across industries. Some of the most important in value investing include:
- P/E (Price-to-Earnings Ratio): Helps determine if a stock’s price aligns with the company’s earnings. A low P/E may indicate undervaluation, especially when compared to industry peers.
- P/B (Price-to-Book Ratio): Compares a stock’s market price to its book value. A low P/B suggests the stock may be trading below its net asset value.
- ROE (Return on Equity): Measures profitability relative to shareholders’ equity. A high ROE signals efficient management and long-term value creation potential.
By mastering these tools, you’ll be better equipped to spot undervalued stocks before the market corrects their prices—just like the greatest value investors do.
