Value investing refers to a particular philosophy that drives the way an investor approaches selecting stocks. It is not shopping the bargain bin for seconds and discontinued models, or buying cheap shares; it is about finding stocks that the market has not correctly priced. The goal is to find a stock that is worth more than is reflected in the current price.
The value investor, perhaps more than any other type of investor, is more concerned with the business and its fundamentals—such as earnings growth, dividends, cash flow, and book value—than other influences on the stock’s price.
Value investors are also buy-and-hold investors who are with a company for the long-term. If the fundamentals are sound, but the stock’s price is below its apparent value, the value investor knows this is a likely investment candidate because the market has incorrectly valued the stock. When the market corrects that mistake, the stock’s price should experience a rise.
The Market Is Right
It is not uncommon for the market to be right, and a stock get hammered because of any number of sound fundamental reasons, such as declining earnings, declining revenues, or a fundamental change in the market or product line.
Take a pharmaceutical company, for example. If they have a top seller yanked out the market by the government, that fundamentally changes the company. On the other hand, other pharmaceutical companies may also see their stock clipped, even though they are not part of the recall. That may make them worth a look by a value investor.
Value Investing Guidelines
When it comes to choosing investments, value investors should settle on a formula that works for them, but at a minimum, it should involved analyzing the following elements:
Price-to-Earnings (P/E) ratio
The price-to-earnings (P/E) ratio is the ratio that measures a company's share price relative to its earnings per share (EPS). If a company's stock price is $25 and its EPS is $5, it's P/E ratio would be 5. Value investors typically look for companies with P/E ratios in the bottom 10% of their sector.
Price/Earnings-to-Growth (PEG) Ratio
A stock's price/earnings-to-growth (PEG) ratio measures a stock's P/E ratio in comparison to the growth rate of its earnings over a specific period. Ideally, you want to find a company with a PEG of less than one.
Debt-to-Equity (D/E) ratio
A company's debt-to-equity (D/E) ratio is found by dividing its total liabilities by its equity. Value investors look for a ratio of less than one.
Price-to-Book (P/B) ratio
The price-to-book (P/B) ratio is found by dividing a company's stock price by its share's book value. A ratio of less than one is ideal.
Along with these measurements, value investors look for strong earnings growth over an extended period—generally, 6–8% over 7–10 years—and never pay more than 60–70% of the stock’s intrinsic per-share price.
Current accounting standards are adequate for measuring buildings and equipment (book value). However, as our economy has moved to more technology and knowledge-base, many of these intellectual assets never show up on financial statements. Value investors acknowledge that their target investment company is much more valuable as an ongoing business than its assets. In many cases, it is the intangibles—patents, trademarks, research and development, and brand—that drives the expectations of future growth, not hard assets.
Coming up with the intrinsic value of a stock is a complicated process, and there are several ways to get to the number. Fortunately, there are several places you can go online to find the number. MorningStar.com calculates the number, which it calls “fair value,” on its site, but you need to be a member to access it. Another good source is Reuters, which is free.
However you arrive at the intrinsic or fair value, give yourself a margin of error with the thought that if the calculation is wrong, you might overpay. If you use one of the services mentioned above or another source to find the intrinsic value, determine if they have already factored in a margin of error. For example, if you believe the intrinsic value is $40 per share, give yourself a margin of safety and lower the target to $36 per share.