Value Stocks Definition
Value stocks are stocks that currently trade below the intrinsic value of the company. A value investor typically considers various fundamentals of the business to determine the value of the company. If the market price is below the value of the company as determined by the investor, the stock is considered as undervalued, or a value stock.
We should note that the market price of the company stock is set on the stock exchanges based on the prices bid and offered by the investors. Therefore, a price normally exists at any given point in time, and can be readily determined by looking at the last traded price in the stock.
The intrinsic value of the company however is a subjective evaluation based on various fundamentals of the business. These could be based on the net assets controlled by the company and may also be based upon the future prospects of the company in the market place. Different investor would value the same business differently based on their understanding of the business fundamentals and their investment horizon. As a result, intrinsic valuation of a company will differ from one investor to another.
Typical Methods to Find a Value stock
Certain financial ratios are typically used to quickly ascertain if a given stock is trading at an attractive valuation. These ratios include Price to Earnings multiple (P/E Ratio), Price to Book multiple (P/B Ratio), Price to Sales multiple (P/S Ratio), Earnings Yield (Earnings/Price expressed as an yield), etc. These are all to be taken as quick rules of thumb, and should not be used as the final judgment of the value.
Ratio Analysis also differs across industries and can also be tweaked according to the age/growth of the company. For example, an asset heavy industry that requires significant capital investment may be better valued using a ratio based on the book value or the invested capital. A service industry such as Information Technology might on the other hand be very asset light and its valuation may include factors such as Revenue/Employee, growth rate, P/E ratios, etc. Investors may also be willing to pay higher multiples for high growth rate companies. A Price Earnings to Growth ratio (PEG ratio) can be used to scale the P/E multiple to account for higher future growth.
Other more classical methods to value a company can include versions of Discounted Cash Flow analysis. Essentially, this attempts to find the Present Value of the cash the company is expected to generate in the future for its shareholders. As can be imagined, the difficulty lies in the fact that predicting future cash flow can be very inaccurate. The discount rate also needs to make an implicit judgment on the risk involved in this investment, which can be unreliable, and also prone to change over time as the company matures. This method is still worth using if it is possible to break the business operations down and approximate some parts to an annuity or a bond like instrument.
Why Should We Value Stocks?
In the long run, the price of a stock approximates the intrinsic value of the stock. However, in the short run there can be many instances when the price and the intrinsic value of the stock diverge. These could be for many different reasons. A value investor expects that the market will eventually recognize the mispricing and correct it, thereby eliminating the divergence. Determining the intrinsic value of a stock therefore establishes a rough benchmark of pricing that the investor can use to determine if a stock is an attractive purchase or if it is expensive and should be sold. Without this reference value, it is impossible to execute a “buy low, sell high” strategy, which is required for success in investing over time.
Please note that as we discussed earlier, the intrinsic value estimate will differ from investor to investor. Therefore, successful investors tend to have many years of experience in valuation and deep domain knowledge of the industry they focus in.