Anybody who has some experience in the investing world has probably heard of the term “value investor”. It sounds like a great idea because all of us in our everyday lives are conditioned to operate with the idea that maximizing value in every area of our lives translates into a higher level of prosperity overall.
Value is simply receiving more for less. If you were to go to a garage sale and find an antique vase and paid $10 for it and later sold it to a collector for $100, that $10 you paid is a fantastic value.
Recognizing Intrinsic Value
In order to understand the idea of value investing, we have to first understand intrinsic value. In the investing world, intrinsic value is the perceived value of a company. Once we take all of the pieces and parts and put them together, we place a value on the company as a whole.
Intrinsic value takes into account both tangible and intangible factors. How skilled is the management, is the product or service they sell in high demand, how much debt does the company have, do they have new products in the pipeline? All of these, and many more, are used to assess the value of a company. In short, value investing requires our understanding of company and stock fundamentals.
Let’s look at our beautiful garage sale vase again. As an expert, you’ve assessed it and noticed that it was truly an antique. There are very few of these items in the market or “vase trading” community and its condition is impeccable. Because of this, you put a value of $100 on it.
You contacted a collector but they were only willing to pay $60. Although they agree with your findings, they are concerned that most collectors won’t know what it is and they won’t pay for its true value because they’re afraid that the value may be inaccurate. You disagree so the sale doesn’t happen. As you can see from this example, one big problem with value investing is that everybody has a different way of assigning value.
Even if two investors can come to a consensus on what constitutes value, determining the value of a company is only the first step that a value investor takes before buying a stock.
Value Is All About Comparing
Here’s another analogy: an old car sitting next to newer models may not be as “cheap” as it may seem at first glance. New cars are already in peak shape so buying those at a high price wouldn’t make a lot of sense but if a used car was purchased for a low price due to its condition, it could be fixed up and sold at a much higher price later.
Now we’re back at the question: If everybody values something differently, how does an investor know when a certain stock (or car) is actually value priced? Warren Buffett, known as the best value investor in the world, has his own way of valuing companies and it works for him. You have to develop your own system and analytical eye as well.
Value Investing: An Example
Below is a chart of Bank of America (BAC) and JP Morgan Chase (JPM). Both of these banks are in an environment where banks are not well liked by investors, but the best looking stock amongst the worst is JP Morgan Chase, while the worst is arguably Bank of America. You can see that BofA stock, shown in blue, has lost much more of its value than has JPM.
Although JP Morgan is thought of as the better bank, would a value investor see it that way? Ask Warren Buffet who recently purchase a large stake in Bank of America because, after thorough evaluation, he decided that it was highly undervalued.
Would you think the same thing? Interestingly, many value investors have said that Bank of America was undervalued when it was actually priced 40% higher than its current value. So, as you can see, value investing may not be entirely straightforward.
Where Do You Find Undervalued Investments & Bargain Stocks?
Now that we’ve given you some background on value investing, let’s discuss the process of finding diamonds in the rough. We’ve put together a few ideas.
1. Start with what you know. Motley Fool suggests that we come up with our own personal stock watchlist. Keep an eye on these stocks and when they hit the “right price” then snap them up. Of course, we’ll have to define what the “right price” is. More on this below.
2. Develop a watchlist using investment research centers. Check out ValueLine.com, Morningstar.com and Zacks Investment Research for more ideas. We cover some of these investment research tools and sites here.
3. Understand what the “fair price” of a stock is. Technically speaking, you’d need to figure out a stock’s discounted cash flow (DCF). If you are able to foresee a company’s future earnings, you can work backwards to see what a good price for its stock would be today. Give this DCF calculator a spin. Forecasting or projecting future earnings are pretty much based on estimates. You may want to add a “margin of safety” to your projections in order to control your risks further: find out the stock’s fair price and peg a price lower than that as your target price. The formula for “fair price” or “intrinsic value”, according to Benjamin Graham, is explained here.
4. Get a feel for a stock’s fundamentals. Some simple rules you can apply:
- Look at earnings growth and the stock’s P/E (Price Earnings Ratio). The lower it is as compared to the average P/E of the stock’s sector, the more undervalued the stock may be.
- Look for stocks whose Debt to Equity Ratio, Price to Book Ratio, PEG Ratio (Price Earnings Growth Ratio) are all less than one.
- Check companies with solid earnings of over 5% for at least 7 years.
In addition, you may also want to check how the overall market is behaving. The general market mood can have an influence on the entire universe of stocks. Also, compare your stock of interest against other benchmarks.
5. Learn about value investing techniques. There are some books out there that focus entirely on this subject. Books like The Intelligent Investor, Value Investing: From Graham to Buffett and Beyond, Getting Started In Value Investing, Sensible Stock Investing are great places to start.
6. Invest in a value oriented mutual fund, index fund or ETF. Here’s a shortcut: you can, of course, opt to invest in a top rated value fund. Some options:
7. Subscribe to newsletters that do the legwork for you. This is another shortcut. You can have someone else make the recommendations; you can then decide whether to act on those ideas or to use them as a starting point. There are newsletters and periodicals that are already dedicated to value stocks and funds. For instance, check out ValueStockGuide.com for a free subscription or ValueInvestorInsight.com for a free trial, where you’ll receive monthly updates. We can’t personally vouch for the material here, but you may want to give them a look.
A Cheap Stock With A Low Price Is Not Automatically Undervalued
Note that a stock whose price was hammered is not automatically undervalued. It is undervalued only if its price is discounted even as the fundamentals remain the same. Also, a stock with a persistently low price (e.g. penny stocks) isn’t necessarily undervalued. There may be very good reasons why the price remains extremely low. A stock may be cheap in price, but not in value.
The “idea” of value investing is easy but knowing when a stock is actually a great value can be tricky. Also, just because a company is priced at a great value doesn’t mean that the stock market will purchase it. Many of the best value investors are long term investors. Warren Buffett believes that unless something changes with a company whose stock he owns, he’ll continue holding on to his investment, “forever.” Perhaps this style of investing lends itself most to “buy and hold investing“, and goes against the popular adage that states that “investors should not fall in love with a stock”.
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