Simply put, value investing involves purchasing of stocks deemed as undervalued through some form of fundamental analysis. However, current valuation of the stock is not in line with the long-term fundamentals of the company and it is likely to correct itself in near-term. Consequently, value investors attempt to make profit by buying the stock when it is being offered at a discounted price.
Ace investor Warren Buffet has propounded the approach of value investing and asserted that the essence of value investing lies in purchasing shares at prices below their intrinsic value. In general, intrinsic value for a company or share is decided on the basis of fundamental analysis without factoring its current market price. However, determination of intrinsic value is quite problematic and there exists no correct intrinsic value.
Principle of Value Investing
Different criteria or principles are taken into consideration during the process of value investing. Few of which have been listed down below. Typically, value investors seek stocks with high dividend yield or below-average price-to-earnings (P/E) or price-to-book (P/B) ratio.
Low Price to Earnings ratio (P/E ratio): Stocks with low P/E ratio are opted by value investors as they are known to historically outperform. Also, with low P/E stocks in hand, the investors are spared of any downside risk. However, its important to remember that price to earnings ratio could be low as investors might want to discount future growth worries in the sector. A classical example is the low p/e ratios currently accorded to PSU banking companies currently, on fears of deterioration in asset quality.
Low Price to Book Value ratio (P/B ratio): The low pricing of the stock in comparison to its book value, i.e. net assets of the company, is indicative of the weak sentiments for the stock or the sector in the market. Thus, protection against any further decline in the stock price makes such stocks attractive for value investors.
Low Prices to Cash Flow: Stocks trading at lower prices in comparison to cash flows are looked upon by value investors as sound cash flow would eventually push the stock price up.
Positive Earning Outlook : Stocks of companies that have reported improved earnings and are further estimated to show upward trend are chased by value investors. As strong earnings provide momentum to the stock and drag it upwards.
Positive Technical Analysis: Value investors go for stocks that are trading in a narrow price-band after the previously registered downtrend. The historic and current price trends help in the determination of likely price changes in the future course of time.