Value investing may sound as if it’s self-explanatory. After all, why are we investing if not at all for value? The thing is, value investing is a unique investing strategy.
This is a strategy that’s mainly rolling on the principles of fundamental analysis. This analysis aims to find the intrinsic, or true, value of a stock or asset.
How Value Investing Works
It’s easy. It’s simply finding a good stock with a price that’s on sale. For instance, you’re buying a phone that’s usually worth $40,000. But you wouldn’t just buy it in the first store you see. What you do is find a store that offers the product at a lower price or with a discount.
A company’s stock can change even if its true value remains the same. You look at the charts, and you can easily see peaks and valleys.
Your goal is to find a stock that has a price down in the valleys. You then hold it until it reaches its true value or peak. You sell it, and you make a profit.
Value Investing Makes Use of these Metrics:
Price-to-Book Ratio (P/B)
This is what we also call the book value. This metric tells you something about the company’s assets and compares them to the stock price.
Here’s the trick. If the price is lower than the value of the assets, the stock has a lower price than its intrinsic value.
Price-to-earnings Ratio (P/E)
This metric shows the company’s track record for earnings. You can use this to see if the stock price is not reflecting all of its earnings. It’s a useful metric for value investing.
Free Cash Flow
This refers to the cash that the company generated from its revenue or operations minus the expenses.
Free cash flow is the company’s remaining cash after it pays all its due to capital expenditures.
If the company generates free cash flow, then it has money to invest in the business. It may even pay dividends or rewards to stockholders. Obviously, this is good news.
Assumptions of a Value Investor
In value investing, you work with various assumptions for your strategy to work.
The first one is this: the market is wrong.
According to the efficient market hypothesis, the market is right. The market prices in all available information and reflect them on the stock price. In other words, there’s no way an investor can outperform the market.
But for value investors, that’s not always the case. There are irrational investors and stocks can move in a counterintuitive manner. That is, the stock may have a price higher or lower than its true value.
The second assumption is this: the market will realize the stock’s true price… eventually.
Of course, the whole idea revolves around the market’s judgment of the stock. Value investing would be tough to work if it doesn’t assume that markets will, one day, realize and reflect the stock’s true value.
The third assumption is this: the crowd is wrong.
More often than not, sentiment drives the market. If you consider the first assumption carefully, you’ll see it inevitably leads to this third assumption.
As a value investor, you must go against the flow and be a contrarian. This means you scrutinize the market’s movements. You don’t easily follow the herd.
Because you know that right, they’re selling the stock they should buy. And they’re buying stocks that they should sell.