Quick definitionCopy link to section
Value stocks are shares in a company that is trading at a lower price in the stock market than what it is worth.
Key detailsCopy link to section
- Value stocks are shares in a company that trades at levels lower than the company fundamentals (i.e. earnings, dividends, sales, etc.).
- A bargain price is characteristic of a value stock in the stock market
- Value stocks are appealing to investors as they view the company as unfavourable for the marketplace and enjoy its prices that are lower than market values
What is a value stock?Copy link to section
A value stock is a share in a company that is appealing to investors because it trades at a bargain price relative to what the company is worth (i.e. earnings, dividends, sales). The idea behind investment in these stocks is that the market is inefficient at valuing the company’s actual worth.
The market’s scepticism towards value stocks is what keeps value investors interested at a bargain price. This scepticism normally stems from bad news, the seasonal nature of business, bear markets, etc. To profit from a value stock, the market must change its perception of the company.
A sceptical market means that value stocks are intended for investors that have larger risk appetites. Due to the higher risk that these stocks pose, value investors are more likely to benefit from a greater return in the long run.
What are the defining characteristics of value stocks?Copy link to section
1) Strong earnings per shareCopy link to section
This is the characteristic that defines winning stocks of all stripes, be they value stocks or growth stocks. You want to invest in companies that sell products or services in high volume at healthy profit margins, resulting in strong earnings per share.
2) Low price-to-earnings ratioCopy link to section
This is where the value in value stocks comes in. You’re looking for stocks that boast strong earnings per share, but with prices that lag behind their industry peers. To calculate price-to-earnings (P/E) ratio, simply divide the stock’s current price by its earnings per share. If you don’t know the stock’s earnings per share, you can calculate it by subtracting that company’s dividends from its net income (assuming this is a stock that issues dividends), then dividing by the number of shares outstanding.
3) Low price-to-book ratioCopy link to section
Another measure of a stock’s intrinsic value, the book value of a stock is its value according to its balance sheet. It’s based on the cost of the asset minus depreciation and amortisation costs. You can calculate price-to-book (P/B) ratio by dividing a company’s stock price by its book value per share.
4) Different reasons for being undervaluedCopy link to section
Value stocks are characteristically undervalued, but there are a variety of reasons why this happens. Here are a few of the reasons why investors might undervalue a stock that sports strong fundamentals:
- Bad news. A mining company’s stock could fall sharply because miners decide to strike, halting work and hurting production. Investors must figure out if that strike constitutes an enduring problem for the company’s stock, or if it offers an opportunity to buy low.
- Seasonal business. The stock of a company that owns and operates swimming pools might see its biggest gains leading up to summer, only to trade at undervalued prices in the winter, when far fewer people swim in pools.
- Cyclical business. Stocks of cyclical businesses go down when overarching economic conditions turn against them. For instance, hotel companies’ stocks have been hammered in 2020, because the COVID-19 pandemic has crushed demand for both business and leisure travel.
- Bear markets. All stocks are at risk of falling sharply during bear markets. That includes value stocks, which might look undervalued based on their P/E or P/B ratios, only to tumble anyway as the broader stock market wreaks havoc everywhere.
- Lack of interest. Sometimes you’ll find a stock that’s undervalued based on its fundamentals for no other reason other than it’s flown under the radar. Perhaps this stock trades in light volume, making it less attractive to big-money institutional investors who prefer more liquidity. Perhaps the stock hasn’t garnered the flashy news media headlines that some of its peers have landed. Whatever the reason, it’s simply struggled to attract attention, keeping its price suppressed.
What are some examples of a value stock?Copy link to section
If you’re looking to put your money in value stocks, then here are some of the best currently around.
1) MGM Resorts International (MGM)Copy link to section
As you might expect, tourism and hospitality stocks offer some of the biggest potential bargains, given the global lockdowns that have paralysed both business and tourism travel. As of early June 2020, hotel and casino chain MGM showed a microscopic price-to-earnings ratio of just 4/1.
2) Southwest Airlines (LUV)Copy link to section
In a similar vein, airline stocks have dropped sharply in price during the massive drop in air travel during the COVID-19 pandemic. When air travel starts to pick up again, Southwest Airlines (early June P/E ratio of 11/1) stands to benefit.
3) NRG Energy (NRG)Copy link to section
NRG has no ties to the tourism and hospitality industry, but it’s a potential bargain in its own right. The electricity generation company sports a P/E ratio of just over 2/1 as of early June 2020, even after its stock climbed more than 50% off its March 2020 lows.
4) Apogee Enterprises (APOG)Copy link to section
Specialising in the design and development of glass products for commercial building windows, framing art, and other uses, Apogee might not resonate as the sexiest business model. But with a P/E ratio below 12/1 as of early June 2020, it could be a viable option as a value stock.
Where can I learn more?Copy link to section
To learn further, check out our courses. They provide the guidelines you need to start investing in stocks today.
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