An investment strategy that involves
choosing to put one’s money into stocks that are trading for less than what one
judges their intrinsic value to be is known as value investing. These investors
believe that the market overreacts to both bad and good news, which results in
stock price movements that do not align with the company’s long term
fundamentals. Hence, a value investor actively seeks out stocks that seem to be
trading less than their intrinsic or ‘book’ value which may be underestimated
by the market.
Source: Slideshare
This overreaction of the market provides
investors with the opportunity to profit by purchasing stocks at discounted
prices. In short, value investing allows an investor to buy a high quality
stock on sale. To discover the underrated stocks, a value investor will employ
a range of financial analysis tools and not simply follow the herd by investing
in popular stocks.
When it comes to value investing, the basic
concept underlying it is quite straightforward. As long as an investor realizes
the true value of something, they can save a lot of money by simply buying it
on sale through value investing. Most people would agree that whether or not
you purchase a new TV at full price or buy it at one-fourth of the market cost
on sale, you receive the same TV with the exact screen size and image quality.
Similarly, stocks work such that a company’s
stock price may change, even if its valuation remains the same. Like TVs,
stocks go through periods of lower and higher demands, which leads to price
fluctuations. However, these fluctuations do not change the value you extract
from investing your money into these stocks. Another key comparison here is with
mutual fund investing. When one starts a SIP in a mutual fund, particularly in
equity investments as bonds prices do not change as much, they will see the
price change as a result of market highs and lows.
However, long term analysis of
equity mutual funds has revealed that they eventually grow significantly in
value over time and yield reasonably higher returns than bonds. Akin to this,
value investors seek out individual stocks, as they are certain that their
market price will grow to reflect their inherent value at some point in the
future. The detective work to discover such stocks is not simple and rewards
are handsome when one is able to discover them. Value investing can be
incredibly lucrative with Warren Buffet being among the popular figureheads
that practice it.
How can an investor assess the intrinsic
value of a stock? In general, the intrinsic value of a stock is a combination
of looking at its financial performance, cash flow, profit, revenue, in
addition to some more fundamental factors like the company’s brand, target
market, business model, and competitive edge. Here are some tools that can help
with this assessment.
● Price-to-book (P/B) ratio
or the stock’s ‘book value.’ This tool is a measure of how the company’s assets are valued compared to its current stock price. If the price to the stock is lower than the value of the asset itself, then the stock is likely to be undervalued. Note that a company could be going through a financial hardship which may reflect similar numbers in its price to book ratio.
● Price-to-earnings (P/E) ratio
This is an indicator of the track record of the company for its earnings. It helps determine how much the stock price reflects the company’s earnings. When a stock price is not reflective of its gross earnings, it is likely to be undervalued.
● Free cash flow
This measure is the amount of cash that is generated from a company’s profits and operations once all expenditure costs have been subtracted. The free cash flow of a company includes operating expenses as well as large purchases called capital expenses. This also includes the purchase of new equipment that is meant to be upgraded. A company that has a lot of free cash flow has the luxury of investing this leftover money into the future of the business. This may involve paying dividends to shareholders, paying off company debt, and issuing any buybacks.
Many other metrics are used as well. Once a
full-scale analysis is carried out, the investor can decide whether they want
to purchase shares at the stock’s comparative value (intrinsic value vs current
stock price) and whether it is attractive enough to take a risk and invest.
Conclusion
Find mutual funds to start high performing SIPs with Tata Capital’s Wealth Management Solutions. Tata Capital’s Wealth Management Solutions cover a wide range of products that include stocks, bonds, SIP mutual funds, and more that can help you finance and protect your family or business.
16 October 2020
5 mins read
Previous Post
