Value Investing: What It Is And How To Use It To Your Advantage
Sarah Sharkey8-Minute Read
October 05, 2021
Everyone loves snagging an item on sale that offers a high value with a lower price tag. The same holds true with investing! That’s when value investing enters the picture.
Value investing is an investment style that is similar to bargain shopping. But instead of searching for discounts at your local thrift store, value investors are on the hunt for deals in the stock market. It is possible to use this strategy to build a profitable portfolio.
Ready to learn more? Let’s take a closer look.
What Is Value Investing?
Value investing is an investment strategy where investors buy stocks they believe to be undervalued by the stock market. This is done in the hopes that the stock price will grow over time to meet or exceed the intrinsic value offered by the company.
The basics of value investing mirror any bargain-hunting experience. For example, let’s say you find a valuable item marked down to 50% off. When you pull the trigger on that purchase, you’ll know that you are receiving more value than the price reflects.
You can think of value investing as a strategy in which you bargain hunt for companies that have more to offer than their stock price reflects.
It is impossible to discuss value investing without paying tribute to its founding father — Benjamin Graham. Graham published “The Intelligent Investor” in 1949, which formalized some of the basic principles of value investing. Essentially, Graham shared that value investors must establish a consistent way to measure a company’s intrinsic value and include a margin of safety before moving forward with the investment.
Since Graham, one of the most famous value investors is Warren Buffet. Buffet has effectively used value investing to create outstanding returns in his lifetime.
How Does Value Investing Work?
Stocks can become undervalued for any number of reasons. The company may be receiving bad press or simply be part of an unglamorous industry that struggles to attract investors due to a relatively boring approach to business.
After all, you’ll see many investors chasing hot stocks like Tesla or an interesting tech startup. But value investors aren’t distracted by media attention or passing fads.
Instead, value investors dive into the nitty-gritty financial details of a company to determine what they believe the company is worth. If the investor believes that the company is worth more than the stock price reflects, then they may move forward with the investment. However, each investor will also include a margin of safety based on their risk tolerance to reduce the chance of losing money if the stock doesn’t perform quite as well as they had hoped.
In general, value investors are ready to hold onto the stock for the long term. Value investing offers an opportunity for slow and steady returns instead of higher-risk investment options such as short selling. In contrast to value investing, short selling is a high-risk investment strategy that encourages investors to speculate that the price of a particular stock will drop in the near future.
Value Investing Example
Here’s an example of value investing to consider.
Let’s say that Sally is exploring companies to find an opportunity as a value investor. After running the numbers on Company A, she determines that the stock price should be $150.
But when she checks out the current price of the company’s stock, it is only $100. With that, she decides to move forward with an investment in Company A’s stock. Once she has invested, she plans to wait until the stock price climbs to its true value.
Plus, there is the possibility that the stock price will rise above the initial true value that she determined. That could lead to additional profits in the future.
Importantly, it is possible to lose money in value investing. With any type of investment, there is some risk that you could lose your investment. Careful study of an individual company should help savvy investors make worthwhile investments. But unforeseen circumstances could always arise to wreck the plans of even the most conservative value investor. It’s best to talk to a financial professional before making any major investment decisions.
How Does Value Investing Differ From Growth Investing?
At odds with value investing is growth investing.
Growth investing involves seeking out companies that are expected to provide strong earnings growth. The goal of a growth investor is to find companies that have attained above-average earnings gains. Most growth investors look for companies that have proven to create these above-average gains for several quarters with the expectation that the company will continue to perform well.
Unlike growth investors, value investors are seeking out companies that are currently undervalued with the intention to earn a profit when the stock price rises to meet the intrinsic value determined by the investor.
So, which is the better strategy?
Each strategy is better suited for a different part of the market cycle. In general, growth stocks tend to have the most potential when interest rates are falling paired with rising company earnings. But as the economy cools, growth stocks may see a sharp drop.
On the other hand, value stocks tend to do better in the early stages of economic recoveries. But in the case of prolonged bull markets, value stock may not do quite as well as growth stocks.
Ultimately, it depends on your unique risk tolerance and financial goals. Consider what type of investment strategy will best suit your portfolio before diving into either option.
How Do You Invest In Value Stocks?
If you’ve decided that value stocks would be a good addition to your investment portfolio, then it is time to choose the right value stocks. Let’s explore how you can invest in these types of stocks.
Talk To An Investment Advisor
If you have an investment advisor, it is smart to talk about your interest in value stocks. In most cases, your investment advisor will be happy to help you in this pursuit.
It is a good idea to get on the same page with your financial advisor so that your portfolio reflects your goals.
Research Stocks To Invest In
Value investing involves heavy research into the details of a company. The goal is to root out companies that have a higher intrinsic value than the stock price reflects.
Intrinsic value offers a measure of what the company’s assets are worth beyond the stock price.
In order to make this comparison, you’ll need to dive into the fundamentals of the company. In many cases, this process will be referred to as a fundamental analysis.
Investors seeking value stocks often look for established companies that have received some bad press recently. As a value investor, you look beyond the short-term consequences and evaluate what the company has to offer.
Compare The Intrinsic Value To The Stock Price
So, how can you determine the intrinsic value of a company?
As an investor, you’ll need to decide for yourself what matters most within the company. You can evaluate the cash flow, physical assets, management team, and more.
But many value investors choose to use the discounted cash flow model to determine the company’s intrinsic value. Essentially, this model established a value for the company based on its expected future cash flows.
The discounted cash flow model can serve as part of a comprehensive fundamental analysis. Within a fundamental analysis, you can look at any factor that might affect the value of a company. These factors can range from cash flow to the larger economic picture and those impacts on the company in question.
Once you arrive at an intrinsic value for the company, it is time to compare this to the stock price. If you find the intrinsic value is higher than the stock price, then it may be a good move for your value investment strategy.
However, you should create a margin of safety. As you may notice throughout the fundamental analysis, there are many factors that are somewhat subjective. It is completely reasonable to assume that a company’s intrinsic value will vary based on the unique analysis done by an investor. Some room for error should be a part of your value investment strategy.
With that, a margin of safety can give you some breathing room in case you’ve overvalued the company. If the stock doesn’t perform as well as you predicted, then you run less of a risk of losing money. The exact margin of safety will depend on your risk tolerance and confidence in your valuation.
Keep Your Investment Timeline In Mind
As with all investment styles, you should keep your investment timeline in mind when determining which stocks to buy. If you have a short timeline, then value investing might not be the right choice. In most cases, value investors are ready to stick around for the long term as the stock price rises to catch up with the intrinsic value of the company.
What Are Some Strategies Behind Value Investing?
As you dive into value investing, there are some strategies to keep in mind.
Don’t Follow The Crowd
When investing in the stock market, it is easy to get swept away by market trends. After all, you can read the headlines that tout one stock or another as the next big thing. Don’t let the crowd pull you away from investments that align with your principles of value investing.
The same sentiment holds true after you buy the stock. Don’t let it go based on market swings. Instead, hold the stock until it no longer aligns with your investment goals.
Find Businesses That Are Making An Impact
Most value investors agree that you should seek out businesses that stand out, not stocks. With that, you should be hunting for businesses that create value in the world even if the stock market doesn’t notice.
It can take some time to find truly undervalued companies. But the effort can pay off. If you struggle to find a stock that fits the bill, consider researching companies in industries that you believe matter. If you can understand the business model, you have a better chance of making the right valuation.
Don’t Underestimate Management
The right management team can help a company thrive. But bad management can run an otherwise valuable company into the ground.
Seek out companies that are managed by reliable teams. You don’t want to place the future of your investment in the hands of a management team that you can’t trust.
What Are Other Investing Options?
Value investing is not the only choice. You can pursue other investment options, such as short selling or growth investing, to achieve your financial goals.
Let’s compare value investing with growth investing and short selling. Here are some pros and cons to consider for each.
Advantages And Disadvantages Of Value Investing
Value investors can enjoy the potential for big profits if the stock price rises to meet the company’s intrinsic value. Additionally, value investing opens the door to working with reliable companies while taking advantage of the power of compounding interest.
On the flip side, it can be challenging to find the patience required to succeed with this strategy. You likely won’t see quick rewards with this strategy. Plus, finding undervalued companies is a difficult task that will require time and effort.
Advantages And Disadvantages Of Growth Investing
The benefits of growth investing include the possibility of picking a stock that outperforms all expectations. Of course, everyone wants to find one of these big winners. With that, it can be difficult to root out the best growth stock.
Unfortunately, an extremely high amount of volatility and the risk of betting on the wrong horse can be a deterrent for those considering growth investing.
Advantages And Disadvantages Of Short Selling
Short selling is an investment strategy that is designed to allow investors to make a profit in a falling market. Essentially, they make this happen by betting that the value of a particular stock will not increase. If the investor is correct, they can earn a profit.
In general, short selling is considered a very risky option. But it could be right for an investor with an extremely high-risk tolerance.
The Bottom Line
Value investing can be a good choice for your investment portfolio. But you’ll need to make sure that this strategy is in line with your financial goals.
Want to learn more about investing in stocks? Check out our tips to get started with stock investing today.
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