Value investing is an investment strategy that seeks to buy undervalued stocks or other securities and hold them for the long term.
The concept of value investing was first introduced by Benjamin Graham, who wrote a series of books about the topic beginning in the 1940s with Security Analysis and coined the phrase “margin of safety” as part of his investment philosophy.
Since then, value investors have used Graham’s techniques or variations to build their own portfolios – some successfully and some not so much.
Jump to a section:
- What is value investing?
- Buy low, sell high
- How to analyze a company’s intrinsic value
- Why value investing works over time
- Risks of value investing
- Value investing vs Growth investing
- Is value investing for you?
What is value investing?
Value investing is a strategy that focuses on buying stocks that are undervalued relative to their intrinsic value.
This means you can buy stocks when they are trading at lower prices than they should be, resulting in greater returns for your money.
On the other hand, if you purchase stocks of a company when its price is higher than its intrinsic value (or fair market price), then you will lose money as time goes on.
Value investing guideline: buy low, sell high
Value investing is about buying low and selling high.
You want to buy when the market is down and sell when it’s up. The idea behind value investing is that you can buy companies that are undervalued.
This means they have been beaten down by the market and their stock price has not yet caught up with their earnings potential.
If a company has a strong balance sheet (meaning they don’t have a lot of debt), it may be considered undervalued because investors see this as less risky than other companies with higher debt ratios.
If another company has a weak balance sheet, it means there’s more risk associated with owning its stock because if something happens to negatively affect its balance sheet, then it results in lower share prices for all shareholders.
However, the goal of the investor is not only to make money off buying low and selling high.
It’s about minimizing risk while maximizing returns over time by finding companies with strong fundamentals, good growth potential, low levels of risk and plenty of cash flow.
How to analyze a company’s intrinsic value
To value an investment, you need to know its intrinsic value.
The common ways of estimating a company’s intrinsic value include:
1. Price-to-earnings ratio (P/E ratio)
If you divide a stock’s current share price by its earnings per share (EPS) over the past 12 months, then you get its P/E ratio.
2. Price-to-book ratio (P/B ratio)
Price-to-book ratio compares a company’s market capitalization to its book value. It’s calculated by dividing the company’s stock price per share by its book value per share (BVPS).
3. Dividend yield
The dividend yield tells you what percentage of a company’s earnings will be paid out as dividends each year.
4. Return on equity
This measures how well a company makes use of its shareholders’ or owners’ money.
This calculation divides net income by total shareholder equity to show how efficiently management uses capital during any given period of time.
In analyzing intrinsic value, you also need to look at the company’s financial statements (balance sheet, income statement, cash flow statement) and other financial documents.
You may also want to consider a competitor’s analysis when determining whether or not a company is worth investing in.
Finally, it’s important that you choose an industry that has lots of potential for growth.
The market share for each industry will vary based on how big it is currently and how much room there is for growth.
A good rule of thumb is that industries with low market shares often have more room for expansion than those with high market shares.
Why value investing works over time
The concept is simple: value investors buy low and sell high.
If you’re buying stocks that are trading at a discount to their intrinsic value and selling them when they reach their true worth, you will make money over time.
Whenever the stock market fluctuates and noise traders who focus on headlines and hype overreact, value investors instead seek out undervalued stocks.
They have an edge because they can see past the temporary fluctuations in price stability.
However, this also means they sometimes hold onto a stock for years before selling it at a profit.
Risks of value investing
When you invest in a value stock, you’re buying into that company’s future.
But even with the best management and strong product or service, there are still risks involved in investing.
Here are some of the most common ones:
1. Market risk
This is simply knowing that you could lose money if the market goes down.
2. Overpaying for a stock
This can be tricky because not every company has its price listed (especially small companies). That said, if something looks too good to be true and you know little about it…it probably is!
3. Buying a stock that is in decline (“downside risk”)
Sometimes stocks just go down due to bad news coming out about them.
How to mitigate the risks of value investing
Investors using a value stock strategy can mitigate these risks and make more money by:
1. Not investing in the first place if they don’t have a strong understanding of how to value stocks and spot opportunities.
2. Holding onto their shares for at least 5 years (ideally 10 or more)
3. Diversifying their portfolios with other types of investments to balance out their risk profile.
4. Dollar or Naira cost averaging into the stock over time instead of buying it all at once.
Value investing vs Growth investing
While value investing is about buying stocks that are undervalued in hopes that they will increase in value, growth investing, on the other hand, involves buying stocks that are already priced higher relative to the overall market price.
Generally, growth investing is more volatile and riskier than value investing.
This is because there is a greater chance that the price will fall when you buy a stock that’s already high. However, for value stocks, the price is already low. The chances of the price falling are smaller.
Is value investing for you?
If you’re interested in value investing, these are some of the things you’ll have to do:
- Have a long-term outlook
Value investors usually hold onto their stocks for years, even decades. They’re willing to wait for strong returns over time.
- Understand financial statements and be able to read them yourself
The stock market is all about buying low and selling high—but how can you buy low if you don’t understand what’s happening with your company or its competitors?
Reading financial statements helps you understand this information better so that when the time comes to sell high (and maybe even sell earlier), you’ll have an advantage over others who don’t bother with details.
- Be willing to do your own research on companies before buying them as investments rather than trading on rumours
You need real knowledge based on experience gained through working in various industries over time so that trends become apparent quickly enough.
Having knowledge means making smarter decisions overall during periods when uncertainty reigns supreme.
Value investing is a great way to build wealth, but there are some risks involved.
To make money from value investing, you need to know what you’re doing and be willing to do your own research.
You can’t just blindly trust the advice of others.
You also need patience and the ability to ride out ups and downs in the market for this strategy to work for you over time.
The goal of value investing is to buy low and sell high, but it’s not a get-rich-quick scheme.
The strategy takes time to work and requires that you do your research before making any investment decisions.