Value investing is a strategy investors can use when considering how to invest in the stock market. It is a strategy to profit in the market by identifying and purchasing stock in a company that is undervalued on the market and selling when the price of the stock rises. Undervalued means that the price of a stock is less than its true value. It is commonly used as a long-term investing approach. Compared to other methods, for example, day-trading, and dollar-cost averaging, value investing generally involves a lower trading frequency.
Value investing is different from value-based investing. Value-based investing refers to investors choosing to invest in companies that share similar beliefs or values as them and may or may not take into account the market price of a stock and its intrinsic value.
Value Investing Strategy
Value investing is a strategy based on the theory that the price of a stock in the stock market can be different from its intrinsic value. One of the examples can be that stock price can change in a short period of time due to favorable and unfavorable news while at the same time the fundamentals of the company remain unchanged, ie. the fundamental value of the company remains unchanged. In this case, a value investor will purchase the stock when the bad news is out and sell when the good news is around.
There are a few reasons other than news coverage that will affect the going price of a stock. First, the economy crashes. Economy crashes are generally large-scale events that affect a large group of stocks or even the whole stock market. The different economic crashes may have different causes, which result in a lack of confidence in the market on a short-to-long-term basis. In this situation, some companies' stocks will decrease in price but they may not be the companies that are directly affected by the crash, which makes them good candidates for a value investor.
Another factor can be that a company is undervalued because they are still under the radar and have little publicity. For example, newer and smaller companies may have a stock price that is lower than how an investor values the company and its potential. Another example can be that there are often trends in the stock market and different industries may be favored by the majority of investors. In this situation, stocks from other industries that aren't hot on the trend may be undervalued.
Last but not least, some companies have different parts and branches of business. At times, some branches may be underperforming, which negatively affects the price of the stock. When the other branches are still performing well, this may lead to the company being undervalued. For example, the ice cream selling branch may perform poorly in winter, but the fundamentals of a food production company may have well-performing branches, making the lower price a limited-time occurrence.
How to Calculate a Stock's True Value
In order to succeed in value investing, it is important to be able to spot an undervalued stock. As value investing takes into account a company's intrinsic value rather than the hype it has in the market at a certain moment of time, getting to know detailed information about the company's operation is very important. This information can be obtained on the company's website or from the company's yearly report.
Intrinsic value is a combination of measuring a company's financial state, profit, cash flow, management structure, and so on. There are different metrics that can facilitate this process.
- P/E Ratio: This is also called the price-earning ratio. This number shows how much a share is earning when compared to its price. For example, if stock A has a price of $10 and earnings per share is $1, the P/E ratio will be 10. For value investors, they will prefer a low P/E ratio, which indicates that the stock price is low when compared to how much the company is making.
- Current Ratio: This ratio compares the company's assets against its liabilities. The formula for it is: Current ratio = Current assets/ current liabilities. For example, if company A has $1,000,000 in assets and $10,000 in liability, its current ratio will be 100. This ratio is a measure of liquidity, which relates to the ability of a company to fulfill obligations within one year, these obligations can be debt and other payables. For a value investor, a large number is desirable as it indicates that the company has significantly more assets than liabilities, which can be a sign that the company is likely to survive through downtimes in the market or in the industry.
- Profit Margin: Profit margin is a calculation that shows how profitable a company is. It is calculated by dividing net profit by total sales. The result will be shown as a percentage. For example, A company has a net profit of $1,000 while it has $10,000 in gross sales. In this case, this company will have a 10% profit margin. A value investor will look for a company with a high-profit margin, which shows that a company can profit while keeping its costs low.
Risks of Value Investing
While value investing can be a great strategy, there are some pros and cons to it. For the pros, value investing can be a good way to overcome the volatility in the market and have a good return from investing. At the same time, value investing involves careful investigation of companies to identify those that are undervalued. And as the market can be overwhelmed by emotion instead of data analysis, a value investor will have to have the patience and the confidence in their evaluation of stock to avoid being affected by news and short-term fluctuation of the market. Also, it may take a long period of time for the price of stocks to reflect their intrinsic value in the market, which may not be a good short-term investing approach.
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