Value stocks are stocks that are currently trading at a price lower than their actual intrinsic price. It basically means that the stocks are undervalued, i.e., traded at a price lower than their true value, making them an attractive investment option for investors.
The intrinsic value of a stock is its “real” value, i.e., true or calculated value. Below are several investing metrics that are used widely in the market to estimate a stock’s intrinsic value.
The three popular investing metrics used to estimate the intrinsic value of a stock are the P/E ratio, P/B ratio, and the Earnings Per Share (EPS).
1. Price-to-Earnings (P/E) Ratio:
The price to earnings (P/E) ratio is the most widely used investing metric in the investment world.
Price-to-Earnings Ratio = Stock Price / Total Earnings
The P/E metric is a popular one because it establishes a relationship between a stock’s price and a company’s total earnings, giving a clear indication of whether it is an undervalued stock or not.
2. Price-to-Book (P/B) Ratio
Another popular investing metric is the price to book (P/B) ratio. The P/B metric establishes a relationship between the stock’s price and its book value. It is also a very efficient way of determining whether a stock is undervalued or overvalued.
Price-to-Book Ratio = Stock Price / Book Value
The book value of a company is determined by subtracting its total liabilities from its total assets.
3. Earnings Per Share (EPS)
Earnings per share is another popular investing metric used to determine a stock’s intrinsic value. It is calculated as follows:
Earnings Per Share = (Net Income – Preferred Dividends) / Average Common Shares
Reasons for Undervaluing a Stock
A stock can be undervalued for many reasons. Common reasons we identified are cyclical businesses, seasonal businesses, market recessions, bad news, and market blind spots.
1. Cyclical businesses
A cyclical business is a business where performance fluctuates with the business cycle. The first example is the airline industry. When the economy slows down, and consumers experience less disposable income, people tend to travel less to save money. Therefore, during economic downturns, airline companies can see lower stock prices due to slower demand.
2. Seasonal businesses
A seasonal business is a business where performance fluctuates with the seasonal cycle (fall, winter, spring, summer). An example is an air-conditioning company. Its strong performance during the summer can be explained by the high demand for consumers wanting to cool down. During the winter, less demand for cooling can cause the stock price to be lower than what it usually is.
3. Market recessions
Due to either a market crash or uncertainty, investors tend to dump a lot of stocks out of their portfolios due to fear of further losses. The sell-offs will lead to stock price levels being generally lower than what they usually are. We saw plenty of undervalued stocks during both the 2008 Global Financial Crisis and the 2002 Dot-Com Bubble.
4. Bad news
Companies can sometimes face bad news that will negatively affect their stock price. For example, when the second Boeing 737 Max plane crashed in early 2019, the aircraft manufacturer’s stock price plunged the next day. However, it is up to the investor to analyze the news and determine the magnitude of its impact on the company’s intrinsic value, and whether it is justified by the price drop.
5. Market blind spots
Lastly, value stocks can just be companies that have stayed out of the market spotlight. Companies that do not usually make it under the investors’ radar can stay trading at low volumes, which can result in a low price relative to its intrinsic value.
What is Value Investing?
Value investing is the act of investing in value stocks. Hence, when investors specifically invest in value stocks to profit out of an undervalued stock in the market, it is referred to as value investing. The investment strategy is primarily based on the idea of “buy low, sell high.”
Investing in value stocks is a highly sought-after investment strategy. It is because stocks that are realistically expected to be priced at a high price are being traded in the market for a lower than expected price. The availability of lucrative stocks at a discounted price offers a huge profit-making opportunity for investors.
Value investing is aimed at benefitting from value stocks in the long term. Hence, value investors invest in value stock at the current discounted price, with the intention of holding it for the long term, and then reaping the benefits from the subsequent price appreciation. Once the market recognizes that the stock is undervalued and its value starts to rise, investors can make substantial profits out of the stocks.
While value investing involves the purchase of undervalued stocks at their discounted prices, the strategy really comes into practice when the investor is truly able to differentiate between undervalued stocks with the potential to gain value and generate profit in the long term, and stocks that are undervalued simply because they lack quality and are not going to generate revenues in the long run.
Margin of Safety
While value investing is considered a highly profitable investment strategy, one cannot deny the risk factor that comes with it. To keep the level of risk in check, investors factor in a parameter referred to as the “margin of safety.” It is a self-determined parameter factored in by investors to leave some room for errors arising from valuing a stock incorrectly.
CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. Through financial modeling courses, training, and exercises, anyone in the world can become a great analyst.
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