Value Investing Definition, How It Works, Strategies, Risks

What Is Value Investing?

Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value. Value investors actively ferret out stocks they think the stock market is underestimating. They believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. The overreaction offers an opportunity to profit by buying stocks at discounted prices—on sale.

Warren Buffett is probably the best-known value investor today, but there are many others, including Benjamin Graham (Buffett's professor and mentor), David Dodd, Charlie Munger, Christopher Browne (another Graham student), and billionaire hedge-fund manager, Seth Klarman.

KEY TAKEAWAYS

• Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.

• Value investors actively ferret out stocks they think the stock market is underestimating.

• Value investors use financial analysis, don't follow the herd, and are long-term investors of quality companies.

Understanding Value Investing

The basic concept behind everyday value investing is straightforward: If you know the true value of something, you can save a lot of money when you buy it on sale. Most folks would agree that whether you buy a new TV on sale, or at full price, you’re getting the same TV with the same screen size and picture quality.

Stocks work in a similar manner, meaning the company’s stock price can change even when the company’s value or valuation has remained the same. Stocks, like TVs, go through periods of higher and lower demand leading to price fluctuations—but that doesn't change what you’re getting for your money.

Just like savvy shoppers would argue that it makes no sense to pay full price for a TV since TVs go on sale several times a year, savvy value investors believe stocks work the same way. Of course, unlike TVs, stocks won't go on sale at predictable times of the year such as Black Friday, and their sale prices won’t be advertised.

Value investing is the process of doing detective work to find these secret sales on stocks and buying them at a discount compared to how the market values them. In return for buying and holding these value stocks for the long term, investors can be rewarded handsomely.

Intrinsic Value and Value Investing

In the stock market, the equivalent of a stock being cheap or discounted is when its shares are undervalued. Value investors hope to profit from shares they perceive to be deeply discounted.

Investors use various metrics to attempt to find the valuation or intrinsic value of a stock. Intrinsic value is a combination of using financial analysis such as studying a company's financial performance, revenue, earnings, cash flow, and profit as well as fundamental factors, including the company's brand, business model, target market, and competitive advantage. Some metrics used to value a company's stock include:

• Price-to-book (P/B) or book value, which measures the value of a company's assets and compares them to the stock price. If the price is lower than the value of the assets, the stock is undervalued, assuming the company is not in financial hardship.

• Price-to-earnings (P/E), which shows the company's track record for earnings to determine if the stock price is not reflecting all of the earnings or is undervalued.

• Free cash flow, which is the cash generated from a company's revenue or operations after the costs of expenditures have been subtracted. Free cash flow is the cash remaining after expenses have been paid, including operating expenses and large purchases called capital expenditures, which is the purchase of assets like equipment or upgrading a manufacturing plant. If a company is generating free cash flow, it'll have money left over to invest in the future of the business, pay off debt, pay dividends or rewards to shareholders, and issue share buybacks.

Of course, there are many other metrics used in the analysis, including analyzing debt, equity, sales, and revenue growth. After reviewing these metrics, the value investor can decide to purchase shares if the comparative value—the stock's current price vis-a-vis its company's intrinsic worth—is attractive enough.

Value Investing Strategies

• Raising prices on products

• Increasing sales figures

• Decreasing expenses

• Selling off or closing down unprofitable divisions

• 2

The key to buying an undervalued stock is to thoroughly research the company and make common-sense decisions. Value investor Christopher H. Browne recommends asking if a company is likely to increase its revenue via the following methods:

Browne also suggests studying a company's competitors to evaluate its future growth prospects. But the answers to all of these questions tend to be speculative, without any real supportive numerical data. Simply put: There are no quantitative software programs yet available to help achieve these answers, which makes value stock investing somewhat of a grand guessing game. For this reason, Warren Buffett recommends investing only in industries you have personally worked in, or whose consumer goods you are familiar with, like cars, clothes, appliances, and food.

One thing investors can do is choose the stocks of companies that sell high-demand products and services. While it's difficult to predict when innovative new products will capture market share, it's easy to gauge how long a company has been in business and study how it has adapted to challenges over time.