Value investing is a strategy that involves investing in securities that appear to be trading at a discount relative to their intrinsic value. Investors focus their attention on stocks that seem undervalued, considering prevailing market conditions as well as underlying fundamentals.
It is common to find potential investments trading at a discount. Stocks of companies can take a hit when they report disappointing earnings results. If that earnings report proves to be a blip, the stock could be well positioned to bounce back.
Value Investing Principles
Value investors try to find undervalued investments in the hopes of future appreciation. Just like any other form of investing, value investing entails detailed fundamental analysis of all the factors that might influence a potential investment opportunity.
Value investing is well suited for long-term investors who are not in a rush to generate returns. In times of market downturns, the value investment strategy tends to perform better than any other strategy as investors get an opportunity to assess securities trading at a discount relative to their potential and long-term prospects.
Value Investing: Price vs. Value
Price and value are the two most important factors taken into consideration when it comes to value investing. The investment strategy places the most focus on the difference between the two metrics.
While the price is the amount that you pay to own a given stock, value is what you get after paying the price. For this reason, value investors try to estimate the value of a given investment prior to paying the underlying price.
Consequently, a good investment would be one whose value will increase as soon as you pay the actual price. Value estimation is one of the most important aspects when it comes to value investing. According to Benjamin Graham, the father of value investing, a good investment whose value has the potential to increase over time needs the following characteristics:
- Current assets are twice current liabilities
- Long-term liabilities don’t exceed net current assets
- Stable profit for several years
- Price to Earnings ratio does not exceed 15
- Price to book ratio is no more than 1.5
Safety Margin in Value Investing
Maintaining a higher safety margin is also an important aspect when it comes to value investing. Safety margin is the difference between the market price that you pay for an investment and the intrinsic value. According to Benjamin Graham, the lower the market price of a stock relative to its true value, the greater the safety margin, and the higher the probability of the investment generating significant returns in the long run.
The safety margin should always be higher as it reduces the potential impact of negative factors and errors that might take a toll on investment value. With a sufficient security margin, it is less likely that adverse events along the way would affect the long-term results of an investment.
Value investing should always be focused on high-quality companies with great potential, not just cheap stocks. Success in value investing will always come down to thorough detailed study and analysis, ascertaining the intrinsic value of an investment as well as underlying fundamentals that might cause the underlying value to increase over time.