Value investment strategy is one of the strategies used in the stock market, where investors look for the companies that have the ability to generate returns at a reasonable level during a sustained holding period. In other words, a value investor tries to find a company that is undervalued by the market, but it has a potential to show an increase in its share value once the market rectifies the error of valuing that firm. So, it allows an investor to buy a well performing share at a cheaper price.
How to Screen for a Value Stock?
Value investors are not concerned with the factors that usually cause price fluctuation in the market. For them, the factors that would impact a stock price are oil prices, inflation reports, wars, and hikes in the Federal rates. This is the reason why they look for stocks with strong dividends, earnings, cash flow, and book value, because value investing is not just about purchasing an undervalued stock, it is about purchasing a good stock that is undervalued. However, just having the strong fundamentals doesn’t necessarily mean it will be a value stock investment opportunity, because a company with strong and consistent earnings growth, attractive cash-flows, decent dividends, and a minimal amount of debt might represent a growth investment, and so, value investors won’t be interested in it.
An investor must keep three questions in mind when he seeks a high value stock:
- How is the cash-flow position of a company?
- If the company is generating profit from its key operations?
- What are the future prospects in terms of growth potential?
How to assess a good value stock? (Just some RATIOS)
- High Dividend Yield – The stock with an ability to generate high dividend yield, is considered a good value stock. However, a comparison should be made in the same industry.
- Low P/E Ratio – It is a comparison between a share price and the earnings generated by each share. Paying less for more profit will be a good indication of a good value stock.
- Low Price to Book Ratio – The lower this ratio is, the better it would be, as it shows how much will be left after the liquidation.
- PEG Ratio – Value investing doesn’t simply means investing in low Price to earning stocks. Another largely accepted metric for finding out the intrinsic value of a company is PEG ratio, which is calculated by dividing the P/E ratio of a stock with its projected earnings growth rate over the years. It measures how cheap a stock can be while keeping in mind the growth of its earnings. Therefore, a PEG ratio of less than 1 means a company is undervalued.
- Net-Net Method – According to this method, if a company trades at 67 percent of its current assets, an investor doesn’t have to adopt any other measure of worth, because it depicts that a buyer is getting all the non-current and intangible assets free of cost. But, there are only a few companies that are trading this low.
Value stocks can be found in any industry, including finance, energy, and even TECHNOLOGY. Yet, they are mostly commonly located in industries that have recently been hit by a difficult time, for example, the cyclical nature of auto industry give rise to a period of undervaluation of companies like General Motors and Ford.
Warren Buffett, one of the most astute investors of all time, learned the art of trading from Benjamin Graham, who was the father of value investing. Buffett has always emphasized that buying a good company at a fair price is far better than buying a fair company at a good price, which is true. Value investing is not about purchasing stocks at a bargain price and hoping for the best, nor is it about making quick money on a market trend. The main idea behind it is to invest in companies with strong business models.
It is important to have a long term strategy with value investing. The investors shouldn’t get faltered by short term market features, such as volatility or daily price fluctuations, because a good firm will not lose its worth even on a bad day. Although, value investment strategy is dependent on a stern screening process, yet, it has a potential to generate reasonable returns in the long run.