Value Investing: Strategies and Pros and Cons

Last updated: July 19, 2020

Investing in some of the best value stocks right now depends on your means to capitalize on inefficiencies in the market. Value investing requires a thorough understanding of the stock market.

Value Investing: How To, Pros and Cons

What is Value Investing?

Simply put, value investing is a long-term strategy to buy stocks where the market price is below the stock's intrinsic value. On the other hand, when a stock is trading at a price higher than its inherent value, investors consider such stock to be overvalued.

Value investors carry the belief that share prices do not justify the long-term fundamentals of a company because such prices are considerably dependent on market behaviour.

How do investors derive intrinsic value?

When looking for value stocks, value investors look at a company's financial history, its revenues and cash flows over the years, business model, future profitability, etc.

They also look at:

  • Indulgence in a financial scam.
  • The credit rating of a company signifying its debt clearing capacities.
  • Profit or loss during the previous market recession.

They might also choose to investigate why stocks of a company are undervalued, and whether they have the necessary organisational and financial capacity to recover from such undervaluation.

In addition to the qualitative indicators, a value investor also analyses multiple financial metrics to arrive at a more concrete conclusion regarding the underlying potential of a company, which are:

Earnings Before Interests and Taxes (EBIT)

It's used to determine a company's cash flow without the effect of secondary expenses and profits. Taxation, here, is a primary factor as its laws allow for certain phenomena that might mask a company's real earning potential.

For instance, a company might suffer losses in its initial years, but if it is founded on a sound financial and organisational framework, it shall generate profits in subsequent operating cycles. However, as tax laws dictate, companies can choose to carry forward their losses into following years to set off against future profits, causing such future profits to be lowered. It masks a company's earning potential. Hence, taxation is left out to determine a company's intrinsic value.

Earnings Before Interests, Taxes, Depreciation, and Amortisation (EBTIDA)

It is a development on EBIT, whereby earnings are calculated after excluding depreciation and amortisation expenses. Depreciation and amortisation are provisions and do not affect actual cash flow. Therefore, it provides a more detailed and precise insight into a company's earning potential.

Discounted cash flow

This is a crucial metric which allows investors to devise a company's future cash flows and find their current value. It uses a discounted rate accounting for price level increase. Investors use this metric to determine the present value of a company and its future potential. As investors learn more on EBIT and EBTIDA, they know whether its stocks are undervalued or not.

P/E Ratio

Price-to-earnings ratio or P/E ratio signifies the relationship between a company's share prices and per-share earnings (EPS).

P/B ratio

Price-to-book value ratio signifies the per unit book value of a company's assets and per unit share price. For a company, the former is derived by dividing the total book value of a company's assets by the market value of its outstanding shares. In case a company's share prices are lower than its per unit book value, it denotes that its stocks are undervalued.

Advantages of Value Investing

Risk minimisation:

In general, investing in equity shares is associated with high risk due to its correspondence with market fluctuations. However, with value investing, investors mitigate that risk by earmarking stocks that are undervalued, and thus, can purchase potent shares on sale. Eventually, these shares would reach their intrinsic prices or maybe go higher, which would allow them to earn substantial capital gains.

Investors of this category use margin of safety to attenuate the associated risk. It means purchasing a share when its prices are lower than a particular limit. Thus, even if they are wrong about a specific company, losses, if any, would not be significant. Benjamin Graham, for instance, only purchased stocks when their prices were 2/3rd of the intrinsic value.

Substantial returns:

Value investing, if done accurately, will give you above-average returns in the long-term.

Disadvantages of Value Investing

One of the primary disadvantages of value investing is that it does not provide higher returns in the short-run and thus compels investors to lock their capital for a considerable period.

Secondly, value investing online or offline consumes a significant amount of time as investors have to dedicatedly seek out companies that are undervalued.

Strategies for Value Investing

The key strategy to invest in undervalued stocks is by using the metrics explained before such as EBDITA, EBIT, P/E ratio, etc. Those of you who are willing to adopt value investing need to properly analyse a company, derive its intrinsic value to realise substantial profits and minimise risk. Another strategy is to keep an eye on companies that have assets which are not properly reflected in their balance sheet. Such assets include intellectual property like patents. Their value might increase in the future owing to market conditions, which causes stock prices to rise substantially.