Want to learn how value investing works? You’ve come to the right place. In this article, we’ll answer two basic questions to help you gain an understanding of what this strategy is all about:
- What is value investing?
- How does value investing work?
If you find that you’re more concerned with the long-term fundamentals of a company than anything else when investing, you may be a value investor and not even know it. Value investors look to capitalize on other investors undervaluing certain stocks. While many investors sell off a stock as negative earnings reports come out, you can buy that stock at a discount – provided you see long-term value in that stock. The opposite is true as well – while investors flock to the hottest new stock, you may see through the noise and purchase an options contract to sell that stock at a premium later on.
We’re going to explain more in-depth what the ideology behind value investing is and how it works. You’ll learn how to identify value stocks, vet them, and trade them to earn solid returns. Let’s start by defining this strategy:
What Is Value Investing?
First things first, what is value investing? As we briefly explained in the introduction to this topic, value investors identify stocks that they can purchase at great market value – relative to what that stock’s actual long-term value is. One famous value investor you’re probably familiar with is Warren Buffet – but there are many, many others.
This is a more long-term investment strategy. You won’t enter and exit positions every few days like you would with swing trading. Thus, you should be able to remain patient and see your plays all the way through if this is the strategy you want to employ.
If you think about it, all investing is technically a form of value investing. Your goal is to buy stocks at a great value anytime you trade, right? You wouldn’t buy a stock if you didn’t see value in that stock. That is the principle many of us follow anytime we purchase anything – including a house, a car, or even a new computer. You always want to get the best value for your money.
The key with value investing is that the strategy you follow uncovers these “value stocks” in particular. Say the vast majority of the market reacts negatively to company news – and they sell off their shares, causing a price plummet. You see this same news and realize that it doesn’t really affect the value of the company – and you look at all technical indicators to discover the stock is way undersold and due for a correction. You can buy that stock at a great value and when it rebounds, you’ll be sitting pretty.
The Advantages Of Value Investing
Value investors enjoy lower risk and solid returns. Because your strategy entails seeking out quality companies with huge upside potential – and getting into your position at a great value – there is much less likelihood of ending up taking a loss. Keep in mind that value investors hold their positions long term. That means you’ll undoubtedly have to ride out some highs and lows. But in the big picture, you’ll come out on top more often than not. At least, provided you follow our tips below to uncover quality value stocks and time your positions correctly.
And because you get into these stocks at such a great value, there is huge upside potential. Value investors can earn substantial profit margins on their investments. Sure, you have to wait a while to realize that profit. But if you aren’t using your investments as supplemental income, but rather long-term wealth generation, it’s a great strategy.
What Are The Characteristics Of A “Value Stock”?
The types of companies value investors seek out share a few similar characteristics. While no two situations are the same, here are a few things that make a great value stock:
- An established business with a track record of profitability
- Stable revenue streams with steady growth (big jumps can scare off some value investors – who fear the company’s best days are behind it)
- The company pays out dividends routinely to shareholders
There are many situations where a company will satisfy all three of these characteristics and still not be a great opportunity for value investors. Because above all else, your goal as a value investor is to find stocks that are currently undervalued relative to their intrinsic value. If a company meets all the criteria above but you can’t buy it at a discounted price – you wouldn’t open a position as a value investor. You’ll only enter positions that have current value relative to their intrinsic value. But – how do you find these types of “value stocks”? We’ll explain more in-depth in the next section. However, it can be as simple as using the VectorVest software to gain insights into a stock’s book or intrinsic value compared to what it’s currently trading at. Our free stock analysis shows you all you need to know to determine if a stock meets your criteria.
How Does Value Investing Work? Tips To Get Started
Now that you have a better idea of what it is, how does value investing work? How does an investor actually go about uncovering these stocks and validating them as a good value buy? There are quite a few types of trading indicators you can rely on that will help you screen for these stocks.
However, most value investors rely on financial analysis more than anything else. Remember – you’re not going to be very focused on day-to-day movements on a chart. You’re looking to invest in quality companies with good long-term value. So, what are the metrics you’ll assess to determine the intrinsic value of a stock? We’ll cover those later on in this section. First, we want to talk about an important mindset shift you’ll have to make as a value investor.
Remember That You’re Investing In Quality Companies First & Foremost
Certain investment styles – such as swing trading strategies – seek to make money through stocks even if the overall trend of a stock’s price is downward. One key mindset shift you’ll have to make as a value investor is to only seek out quality companies first and foremost. If a company has “good bones”, you can trust that it will appreciate in the long run – despite bumps along the way. Tune out the noise and the short-term market trends and focus on finding quality companies at a good value – if you can do this, you’ll enjoy great success in value investing.
Better yet, invest in quality companies that you actually know and love. Value investing is going to entail some degree of risk – after all, you’re making an educated guess as to the long-term trajectory of a company. If you’re more familiar with a company, your educated guess becomes less of a “guess”. You know how the company operates, and if you understand its mission, you’ll have a better idea of what the true value is.
Pay attention to management as well. If a company is poorly managed, you need to steer clear – even if the price is trending upwards. On the other hand, a company can be trending downwards but bring in new management. And if they invest in good management, it bodes well for the long-term valuation of the company. Remember – many investors will see news about management shifts as a reason to sell off their shares. Meanwhile, you’ll see through the chaos and recognize that this is actually a good thing for the company as far as the big picture is concerned.
In summary, focus on finding quality companies and assess their standing in the big picture. Focus less on technical indicators, short-term trends, and that type of stuff. With that said, there are a few forms of technical analysis you can conduct to identify the true value in a company.
Learn How To Read PB & PE Ratios
The price to book ratio (P/B) shows you a comparison between a company’s assets valuation and the stock price. At the very least, a company is worth the value of its assets, right? Oftentimes you’ll find companies that have a stock price below the value of their assets – and these stocks are considered undervalued. As a value investor, you can capitalize on these opportunities – knowing the intrinsic value of the company stock is greater than the market value. And like we said earlier, this is part of what makes trading with VectorVest so effortless. You can easily get an idea of what a company’s intrinsic value or book value compared to what it’s currently trading at.
Another really important ratio to look at is the price to earnings – or the PE ratio. This gives you an idea of whether a company is undervalued relative to the earnings it brings in.
Identify Companies With Ample Free Cash Flow
Free cash flow is exactly what it sounds like – how much cash a company has generated from operations after operating expenses have been subtracted. Free cash flow also takes into account capital expenditures – so if a company invests a lot of money into new processes or equipment, this metric will reflect that. So, while a company may be unprofitable on paper, you can see the long-term value in the said company as they’ve invested heavily into R&D, better equipment/process, etc.
Other Strategies For Uncovering & Vetting Value Stocks
Many investors will also examine the EBITA and EBIT metrics of a company if PE, PB, and free cash flow still leave questions unanswered. Another strategy to find undervalued stocks you can capitalize on is to consider unaccounted for assets. These are the type of assets that don’t show up on a balance sheet: partnerships and patents.
If a company has a partnership with the US government as the sole provider of a certain good or service, it’s safe to say that stock has long-term value. Similarly, if they are the only company that can do something (intellectual property), that company has intrinsically high value. But, either partnerships or IP will be found on an income statement or balance sheet – so be sure to take the entire picture into account.
What Is Value Investing & How Does It Work? Parting Thoughts
As you can see, value investing is a great way to take advantage of the market overreacting to news and underappreciating a stock’s intrinsic value. Whether you consider yourself a “value investor” or not, you can likely appreciate why this strategy is so important to understand. If you can find stocks that the market undervalues, you’ll make a killing as an investor. And the best way to continually uncover these stocks and determine when/how to enter and exit your position? Using VectorVest’s stock forecasting tools. We have built-in screeners for this exact strategy that return blue-chip companies with solid fundamentals that have been unfairly beaten down by the market. If you’re a value investor, you’ll love how easy it is to uncover opportunities that align with your trading strategy in our software!
Whether you’re trend trading or swing trading, purchasing stock warrants or stock options, one thing is for sure: VectorVest will transform the way you invest. Our software makes it easy to trade at a high rate of success by telling you what to buy, when to buy it, and when to sell it. It’s never been easier to identify winning opportunities and time your positions to perfection. You can try the system risk-free today and see the hype for yourself – we’re confident you’ll never go back to investing the old way. See it in action with a free stock analysis! Or, learn more about this strategy in our article comparing value investing vs growth investing.