Value stocks are those stocks that tend to trade at prices below their intrinsic values.
Value Stocks Meaning
The intrinsic value of a stock is calculated through various models based on fundamentals of the stock like dividends, earnings, sales, etc (also read Fundamental Analysis of Stocks).
Value investors are of the opinion that the current market price of the stock is low because of reasons other than the operations of the company like the presence of other hot stocks or the sector is out of favour at the present instant.
Therefore, they want to take advantage of the mismatch between the stock price and performance of the company by buying value stocks at lower prices and then, selling when the market has finally caught up and raised the price of the stock.
Some common ways to identify value stocks are as follows –
The current stock price is lower in comparison to other companies in the same sector due to temporary glitches like the negative sentiment in the market due to some legal problems or unsatisfactory earnings reports in a quarter etc.
Value stocks mostly are of stable companies with consistent dividend issuance that are temporarily experiencing unfavourable events.
Sometimes, value stocks belong to those companies which have recently launched their IPOs and awareness about them is less in the market.
A company that used to make losses has turned around and started showing profits from the last few quarters and the market has not factored that in yet.
A company has been repaying its debt on a regular basis which is constantly decreasing the interest cost and the market has not factored that in the stock price yet.
But there are certain questions that a value investor must ask before selecting a stock like:
Does the stock look like a bargain because it belongs to a dying industry?
Is there any unforeseen problem due to which the price of the stock is quite low?
Is the current problem in a company (if any) because of which the stock looks like a bargain short term or long term?
And is the management fully aware of it and taking or going to take any steps to cure it?
Benjamin Graham is considered to be the father of Value Investing.
One does not need to find the stocks with the best ratings because chances are that those stocks are already correctly valued or overvalued.
Therefore, one should focus on stocks that have an average or better quality rating given by a reliable agency like CRISIL.
2. Amount of Debt on the Company
The healthy debt to equity ratio should be less than 0.5 because a higher debt would mean more liabilities and costs which may decrease the overall profitability of a company.
Also, one must keep in mind that the financial ratios should be compared with peers in the same industry in order to make more sense. The debt to equity ratio of companies of the certain industry could be overall higher than debt to equity ratios of companies of some other industry.
Therefore, it is imperative to compare the debt to equity ratio of a company with its competitors. Also, in comparison with its previous years’ ratios can also help in analyzing the financial health of the company.
3. Current Ratio of the Company
The current ratio is calculated by dividing current assets by current liabilities. The value of the current ratio for a company should be greater than 1.5. This is because one should make sure that the company has enough cash to bear any downturns in the economy.
Cash tells us the ability of a company to meet its expenses, pay dividends, repay its loans and invest in expansion activities without taking any loans or raise funds by other methods. Also, do compare the current ratio of the company with its peers to make better sense of the number.
4. No Earnings Deficit
This is a very important criterion to judge the financial health of a company. The earnings per share should be increasing during the last 5 years with absolutely no earnings deficit.
It is much safer to invest in such companies as compared to companies which have been showing earnings deficit in the last few years.
5. Check the Price to Earnings Ratio
Ideally, the price to earnings per share (P/E) of a company should be 9.0 or less. It would mean that the company is selling at a bargain price.
Although it is one of the quickest ways to identify a value stock, it is not the only criterion that should be used primarily because of its limitations in certain situations. P/E ratios can be misleading sometimes.
6. Check the Price to Book Value (P/BV) Ratio
Book value is a good indicator of the underlying value of a company.
One should invest in stocks with price to book value ratios less than 1.20. This ratio is calculated by dividing the current price by the most recent book value per share for a company. One would ideally find value stocks that are trading near or below their book values.
7. Check the Dividends too
Although value stocks are not the ones which are invested for dividends, they are definitely the ones for which one has to wait for medium to long-term to reflect shares prices according to their actual values or worth.
That waiting period can be exhausting but if a company pays regular and decent dividends, then, the wait does not exhaust an investor. It becomes easier to wait for the correct timing to reap benefits from a value stock.
8. Know the Management of the Company well
Although it looks like a trivial point, in reality, it is one of the most important criteria to select value stocks for investing, especially because value investing involves holding stocks for a longer duration of time, unlike trading where traders are concerned about the stock price just for a few days or months.
In the longer run, management of the company has an immense impact on the operations of the company. One must check the qualification, experience and efficiency of the management before making a selection of stock.
Management is one of the biggest forces that come to rescue in times of difficulties.
Value investing is an art that can be mastered with a lot of knowledge, patience, skill and experience.
One must have the confidence to move in a different direction than the crowd because by virtue of the definition of “value investing“, one is looking for those stocks that are not in the hot list of the majority of the investors.
One must have the patience to wait for months, years or even decades for the stock price to finally catch up with its intrinsic value. Without these two virtues, value investing is not possible. Other than these, one must be thorough in the analysis of companies through reading their balance sheets, income statements and cash flow statements.
One must know the different financial ratios used to analyze particular aspects of the companies and compare them with the peers.
Other than the numbers, one must pay attention to the quality of the management and read the management discussions of at least previous 5 years’ annual reports in order to know how well the management of a company is addressing its problems and if they are fulfilling their promises timely or not.
All the factors when combined show the true picture of a company.
Apart from these, one must always be aware of the current happenings that may affect the performance of his/ her stocks in the longer term. It is not advisable to just sit and wait for the stock price to rise, one must remain updated with all the knowledge around so that one is able to reconsider his / her position if needed.
So, one needs to keep eyes and ears open all the time in order to enjoy good returns from value investing. This is what makes value investing different from other methods of investing.
Benjamin Graham says, “The best investment decisions are based on facts, not speculation.”
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