Value investing is one of the most popular investing strategies. Value investors are primarily interested in buying stocks with strong fundamentals that are also underpriced. These are solid stocks available at a bargain price.
Value investors are looking for stocks that the stock market undervalues. The value investor believes that the market will eventual recognize the inherent value of these stocks, and the price will adjust accordingly.
There are several things that value investors seek in a value stock:
1. The stock has a low price to earnings ratio.
It’s important to compare your target stock with stocks in the same industry. Many investors target those companies in the bottom 25%. Companies with healthy earnings and a low stock price are good targets to pursue further.
2. Stock price is less than 70% of the intrinsic value.
The intrinsic value is the perceived value of the company. In reality, this factor is the difference between your assigned intrinsic value of the company and that of the market. Do you know something the market is failing to see?
3. The current assets are significantly higher than the current liabilities.
Value investors often target a 2 to 1 ratio. Current assets and liabilities are those falling within the next 12 months. Liabilities are bills due in the next year and assets are anything expected to be converted to cash.
4. The debt to equity ratio is less than one.
The company’s equity should be greater than the amount of debt. Companies with excessive debt are frequently in significant trouble, or will be soon enough.
5. The price/earnings to growth ratio is lower than that of comparable companies.
Remember that PEG is the price to earnings ratio divided by the growth rate of the earnings. This value can indicate that a company’s stock price doesn’t reflect its earnings growth. A ratio of less than one suggests a good opportunity.
6. The dividend yield is high.
The dividend yield is the annual dividends paid divided by the stock price. Target companies with a dividend yield that is 65% of the long-term AAA bond yield.
A respectable dividend is a sign of a healthy company. It’s also a sign of a non-growth company. Growth companies prefer to reinvest their earnings.
Note that many of these values are easy to either find or calculate. Being a good value investor is largely a matter of following a disciplined approach. Determining the intrinsic value is the challenging part. Take your time and educate yourself. There are numerous resources detailing the process of this challenging task.
Be sure to include a safety net in your calculations. When you have to make an educated guess, as with the intrinsic value, be conservative. Since there’s no way to be certain you’re correct, assume you’re not and adjust your values to the conservative side. Letting a few good companies slip through your fingers is better than taking a significant loss.
If you had to outrun a lion and your calculations suggested you’d need at least a 50-yard head start to survive, you’d probably give yourself more than 50 yards. You might have made a mistake in your calculations or failed to notice the mud on the other side of the first hill.
Avoid the situation where your calculations have to be perfect to assure success. Make room for error and unforeseen circumstances.
Many investors find value investing to be tedious and boring, but value investors have been very successful over long periods of time. Value investing can be an effective strategy for all levels of investors. Find a few good companies at a bargain price and watch your portfolio grow.