ENAre you someone who believes in long-term wealth building rather than quick market gains? If yes, then value investing might just be the right strategy for you. Rooted in the principle of buying undervalued stocks and holding them until they reach their true potential, value investing is all about patience, research, and a keen eye for opportunity.
By focusing on companies with strong fundamentals and sound financial health, investors aim to benefit when the market eventually recognises the real worth of these stocks. Let’s understand what value investing really means, how it works, and whether it suits your investment style.
What Is Value Investing?
Value investing is a method where the investor selects stocks that have a market value lower than their intrinsic value. Such stocks are assumed to be underpriced and the investor holds them until they reach or exceed their true price. This method is done on the premise that undervalued stocks will appreciate their value over time and yield profits for the investors who hold them long enough.
Investors opting for this method of investing search for companies with strong fundamentals by analysing their cash flow, earnings stability as well as debt ratios. Apart from the statistics, the investors also consider other factors such as industry trends, competitive advantages and disadvantages, and management strategies. This method requires patience as well as strong analytical skills.
How Does Value Investing Work?
Value investors believe that short-term market fluctuations can result in the share prices deviating from their intrinsic value. They begin their search for potential stocks by analysing the company’s fundamentals and filtering the stocks that might be trading for a price below their worth.
After purchasing the chosen shares, the investors hold on to the stocks believing that the market will eventually realise their true worth, resulting in capital appreciation. The investors chose the share by keeping a margin of safety - the difference between the intrinsic value and the stock's market price. The value of the safety margin depends upon the investor's risk tolerance.
For instance, let's say Company X is widely expected to perform exceptionally well in the coming months. As a result, its stock price rises from ₹150 to ₹190 based on market hype. This surge in demand further pushes the price up to ₹240. However, after conducting a thorough analysis of the company’s financials and internal structure, it’s revealed that the fundamentals don’t justify such high optimism. The intrinsic value is estimated at only ₹130, indicating the stock is overvalued by ₹110 and may be riding on unrealistic expectations.
Top value investors typically avoid following market trends driven by hype and instead focus on identifying stocks of companies with strong long-term fundamentals. Despite their solid foundation, these companies may be undervalued due to temporary market factors or sentiment-driven dips in stock prices.
In simpler terms, value investors target businesses that show long-term promise but are currently underpriced due to short-term market distortions. They rely on in-depth analysis and key financial indicators to pinpoint companies whose true potential is not yet reflected in their market valuation.
How Do Investors Derive Intrinsic Value?
The investors carry out fundamental analysis of the companies of their chosen stocks. These stocks are believed to be undervalued, so verifying them before investing is important. Hence, the investors conduct thorough financial analysis and stock valuation using various metrics. Some of the useful metrics for evaluating a company’s stocks are as follows:
- Price-to-Book (P/B) or Book Value
The difference between a company’s total assets and liabilities is its book value. This ratio helps to understand the worth of a company in terms of its books of accounts. This ratio can be calculated by dividing the latest closing share price of the company by its most recent available book value per share.
- Price-to-Earnings Ratio (P/E) or Earnings Multiple
It is calculated by dividing the current share price by earnings per share (EPS). This metric denotes the amount that each investor pays for each buck of a company’s reported profit. This metric is very useful to determine if the stock is undervalued or overvalued.
- Free Cash Flow
Free cash flow is calculated by subtracting the capital expenditures from the cash from operations. This value denotes the funds available to the shareholders after deducting the expenses and investments.
- EBITDA - Earnings Before Interest, Tax, Depreciation and Amortisation
It is a different way of calculating the profitability of a company. Including the amounts of interest, tax, depreciation and amortisation depicts how much a company is profiting from its core business activities. This parameter can be preferred over EBIT for asset-intensive companies.
- EBIT - Earnings Before Interest and Tax
EBIT can help an investor understand the business's cash flow pertaining to the core business activities as it removes secondary expenses and profits from the equation. EBIT is also called operating income.
While assessing the stock of a company, it is important to consider various factors such as equity, debt, revenue growth, earnings per share, etc. Apart from the ratios and technical aspects, other qualitative factors include industry, corporate governance, business model, etc.
Once the investor carries out the analysis, they can estimate if the stocks are undervalued and carry the required margin of safety. Based on these parameters, they decide whether to purchase the stock.
