Value stocks are those stocks that are considered to be under-valued in the stock market. Many investors believe that market over reacts to any news, resulting in stock price changes which do not accurately depict the strength of the underlying fundamentals of the company. Hence, such stocks that are currently trading at a price below the intrinsic value of their company are known as value stocks. Investing in value stocks or value investing is an approach based on the premise that the market will eventually take cognizance of the true potential of these stocks and hence the price will regain pace resulting in good profits.
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How Do Value Stocks Work?
Value investing is based on the basic concept of buying and selling. If the actual value of any product is known then you can buy it at a discount and sell it at a higher value. This is how value investing for stocks works. The investor identifies the best value stock, then buys it at a discount and holds it till the time it reaches its actual value to derive huge returns.
For instance, buying a TV on sale or at full price won’t make any difference in picture quality or screen size. Similarly, buying stocks at a price lower than its intrinsic value, acts as a discount on purchase of high value stocks. But, unlike TVs, sale/discount offers on stocks won’t be advertised and displayed publicly. You, as a realistic and analytical investor, will have to find those stocks that are trading cheap to invest now, so that you can reap the returns in future.
Features Of Value Stocks?
As they are undervalued, value stocks are cheaper than other stocks such as growth stocks. One of the characteristics of value investing stocks is the high dividend yield (due to underperforming security), a low price to earnings ratio. Another important feature of value stocks is there is lesser fluctuations in price both during market highs and lows.
How To Identify A Value Stock?
The value investors are said to earn profits from those shares which are trading cheap or at a discount. To determine whether the share is trading at a discount, investors first need to identify the intrinsic value of the value stock.
Intrinsic value is a combination of studying the financial structure, cash flows, revenues and profits as well as fundamental factors like brand, business model, market structure, etc. This is an important factor to consider while selecting the best value stocks to buy. Some measures used by investors to calculate the value of the stock of a company are as follows:
Price-to-book ratio (P/B ratio)
Price to book ratio is calculated by dividing the company’s stock price by its book value per share. Book value means the total assets minus any liabilities. Low P/B ratios can be indicative of undervalued stocks, and can be useful when finding a value stock.
Price-to-earnings ratio (P/E ratio)
Price to earnings ratio is calculated by dividing the company’s stock price by its earnings per share. P/E ratio helps to determine the relationship between the stock price in the market and its actual earnings as per books. Low P/E ratios indicate that the stocks are undervalued and thus have a chance of future increment in share price.
Price-to-sales ratio (P/S ratio)
Price to sales ratio is calculated by dividing the market capitalization by the company’s total sales or revenue. Market capitalization means the total outstanding shares multiplied by the share price per share in the market. A low P/S ratio indicates a good buy as the stock is undervalued.
Free cash flows
Free cash flow means the net cash generated by the company after subtracting all the operating and capital expenditure. If the company has free cash flows then it will have money for future investments, pay off debts, declare dividends, etc.
Besides these there are other metrics to analyse the actual worth of the company and its shares. While shortlisting the best value stocks to buy , investors must ensure that they know about the company’s financials, competitors, product offerings and corporate governance track record. These will represent the fundamental strength of the business. After looking at all these aspects, investors can decide on whether a stock is a value stock and hence capable of giving you good returns in the future.
Importance of valuation of stocks
In an ideal situation, the share price in the stock should be equal to its intrinsic value. In long run, the price of stock will be approximately equal to its value, but the same doesn’t exist in the short run for various reasons. The reasons could be macroeconomic disturbances, or the cyclical nature of the sector the business belongs to. The value investors expect the market to eventually recognize the mispricing and correct it. This is why experienced investors participate in value investing by going for fundamentally strong stocks, trading at a low price.Thus, determining the intrinsic value is the primary benchmark to decide whether the stock is cheap to buy or it is overpriced to be sold. Without this reference point, it will be impossible to execute the “buy low, sell high” investment strategy.
While looking for the best value stocks to buy, investors must base their decisions on their own research, financial goals and risk appetite and treat the “ best value stocks for the year” lists released by media with discretion. It is imperative to analyse the type of industry in which the company is and its future prospects as well as familiarity with the inherent risks of the industry.Another important factor to keep in mind is that value investing is a long term investment strategy and hence investors must be prudent with company selection and then remain patient to allow their investments to reap results.