Every investor has a certain style, but knowing what kind of investor you should be isn't always easy. Whether you gravitate toward value investing, growth investing, dividends, options, or another strategy will probably be determined by your own financial needs, time horizon, and personal appetite or tolerance for risk.

Value investing has been popularized by Warren Buffett, the CEO and Founder of Berkshire Hathaway, who is regarded as one of the best investors as his company has generated annualized returns of more than 20% over the last 50 years, more than doubling the growth rate of the S&P 500.  The strategy tends to appeal a wide and diverse swath of the investing community, because it's one of the most intuitive strategies for putting your money in the market. Essentially, value investors try to buy stocks that are undervalued, or selling for less than their worth. It's the investor equivalent to bargain-hunting at the mall.

Below, we'll take a look at the basics of value investing, what the goals of a value investor are, and whether value investing is right for you.  

A man with paperwork on his desk punches numbers into a calculator

Image source: Getty Images.

What is value investing?

Pioneered by Benjamin Graham, who wrote The Intelligent Investor, value investing essentially teaches that investors should seek to find the intrinsic value, or the actual value of the company based on cash flows and assets. One of the main methods of doing so is discounted cash flow analysis, which attempts to derive the intrinsic value based on a formula that applies a given discount rate and an estimated growth rate to future cash flows. Value investors also focus on the price-to-book ratio, which shows how a stock is valued in relation to the net assets on its balance sheet. The closer the price-to-book ratio gets to one, the more it will appeal to value investors.   

When they find that the intrinsic value of the stock is significantly less than the market price, or that it affords a margin of safety, which is basically cushion of a certain percentage that helps protect the investment , they should buy the stock. Investors apply a margin of safety, say 20%, to ensure that even if their calculations are off, they will still make gains on the investment. For example, an investor with a 20% margin of safety would buy a stock worth $10/share in intrinsic value when the price falls to $8/share. Once the value is more in line with the price, they should sell it and look for another value play. Because of the margin of safety, they should still make money on their investment even if their estimates were imperfect.

Even with such formulas like the discounted cash flow and margin of safety considerations, there's no exact way to determine a stock's intrinsic value, as even Graham himself acknowledged. Such techniques are probably too technical for most individual investors, but it's easy enough to incorporate some of the principles of value investing without detailed calculations.

So what would the alternative look like? Growth investing, another popular investing strategy that is generally seen as the opposite of value investing, focuses on stocks with high sales and earnings growth. This approach tends to ignore or downplay more fundamental valuation metrics that are central to value investing, and growth investors prefer to look at qualitative factors like disruptive capabilities or optionality as they believe such qualities will guide them to market-crushing returns. 

It's important for value investors to understand the many ratios and metrics that can guide them to undervalued stocks. Those include:

  • P/E ratio: Price per share/Earnings per share.
  • P/FCF ratio: Price per share/Free cash flow per share. All other things being equal, the lower P/E or P/FCF valuation, the better the stock's value as its earnings or cash flow is selling for a cheaper price. 
  • PEG ratio: P/E ratio/Earnings growth rate. Like the other ratios above, a lower PEG is better. Below 1 is best.
  • Debt/Equity ratio: The percentage of total liabilities/total equity on the balance sheet. Value investors tend to be wary of too much debt, but debt/equity ratios vary from industry to industry as some are more capital-intensive. The best way assess a company's D/E ratio may be to compare it to its peers. 

Who are typical value investors

Investors are attracted to value investing for different reasons. For some, it makes the most intuitive sense. They may believe that growth investing is too prone to risk or market crashes, and it's a preferred strategy for risk-averse investors. Other investors that may choose value-investing are retirees or those approaching retirement, or income investors as the strategy appeals to those with shorter time horizons or those who are in the market for an income stream or wealth preservation. 

Value investors are also content to pass up on high-growth opportunities. For example, even though stocks like Amazon and Netflix have delivered blockbuster returns in recent years, their high valuations mean they are vulnerable to having their stock sent tumbling by a weak earnings report or a market crash.

Value stocks, which are less likely to crash, allow investors to sleep more easily at night. For some investors, the value-focused approach may work best for them as it's better suited to their way of thinking, their personality, or their risk appetite.

For other investors, the decision to focus on value may be more determined by their time horizon and age. Older investors such as retirees living on fixed incomes don't need to take risks on profitless growth stocks that may not pay off for several years, and are likely better off with a diversified portfolio of profitable, dividend-paying value stocks that will protect their assets, grow alongside the market, and generate a steady income stream through dividends, which are a share of a company's profits paid out to investors, usually on a quarterly basis. 

Warren Buffett

Berkshire Hathaway CEO Warren Buffett. Image source: Motley Fool.

Goals of value investors

The primary purpose of value investing is best summed by Warren Buffett's famous investing aphorism, "Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1." 

Above all, value-investing teaches investors to preserve their assets by buying stocks that won't lose their value. This is why Buffett has historically avoided riskier investments like tech stocks; he wisely eschewed the sector during the bubble years, which saw a number of tech stocks go to zero. Buffett and value investors like him prefer to focus on companies with steady cash flows that are well-known brands that are unlikely to buckle in a recession. 

Coca-Cola, for example, is one of his favorite stocks. It has a global brand and distribution network, and has been the worldwide leader in soft drinks for nearly a century. Buffett once said that if you gave him $100 billion and told him to unseat Coke as the leader in beverages, he'd give it back to you and say it couldn't be done.  

Buffett himself, whose Berkshire Hathaway conglomerate has returned an annual average of more than 20% since its founding more than 50 years ago, has said that the key to Berkshire's strength comes from its ability to withstand bear markets, not from its surges during the bumper years. Other value investors think similarly. Choosing undervalued stocks is the best way to adhere to Buffett's aforementioned rule, because already cheap stocks shouldn't have much room to fall, even in a market downturn.

In addition to preserving wealth and not losing money, value investors, like most who are picking individual stocks, aim to beat the market. If investors are applying value-investing principles effectively, they should be outperforming the market by choosing stocks that are trading at a discount. Once again, Buffett's record here is indisputable  -- Berkshire has trounced the market, and its early investors have gained more than 1,000 times their original investment -- thanks to his stock-picking ability and the acquisitions he's made as he searches for "wonderful companies at a fair price."

Value investing today

The post-recession years haven't been so kind to value investors. Growth stocks like the "FANG" group of tech stocks have crushed traditional value plays, and the market's valuation as a whole has soared, making it difficult to find bargain stocks.

The S&P 500's P/E ratio is now 24.5, compared to a historical average of 15.7, and a P/E of less than 15 shortly after the recession.  Even Buffett lamented high market prices in his recent shareholder letter, complaining that inflated prices made it hard to find a reasonably priced company to buy. In explaining Berkshire's massive cash hoard of $126 billion  , he told investors: "Prices for decent, but far from spectacular, businesses hit an all-time high. Indeed, price seemed almost irrelevant to an army of optimistic purchasers." 

In such an environment, the best thing for value investors to do may be just to sit on the sidelines and wait for prices to come down. As interest rates rise making bonds more attractive, stock valuations are likely to moderate, setting up more opportunities for value investors. Therefore, Buffett's wishes for stock valuations to fall are likely to come true if interest rates continue to move higher.

Despite the market's high valuation, there are still some value stocks to be found. Below is a sample of a few stocks trading at low valuations.

Company Ticker What the company does P/E ratio
General Motors (NYSE: GM) One of the world's biggest carmakers, it's the parent of brands like Chevrolet, Buick, and Cadillac 5.7
Apple (NASDAQ: AAPL) Designs and manufacturers electronics like the iPhone, iPad, and Mac computer 17
Goldman Sachs (NYSE: GS) One of the world's foremost investment banks 12.5
Southwest Airlines (NYSE: LUV) It's a major domestic airline 9.5

Source: Yahoo Finance

Is value investing right for you?

If you're trying to select the best investing strategy for you or wondering if you should be a value investor, the best way to decide may be to ask yourself a few questions. When will you need the money you're investing? What is your time horizon? Do you want your investments to produce income? Are you afraid of losing money?

The chart below might help.

Question If You Answer Yes If You Answer No
Do you have a time horizon of more than 10 years? Value investing may not be the best way to maximize your growth. Value investing may be a smart strategy for preserving your wealth and growing your assets. 
Are you seeking income from your stocks? Good news. Value stocks often pay dividends. Consider a portfolio that leans more toward growth stocks.
Are you afraid of losing money? Value-investing is a good match for you. You will want a riskier portfolio than just value stocks.
Do you want to spend a lot of time monitoring your investments? Value stocks can work, but don't be afraid to look at something more volatile. A buy-and-hold value-investing strategy is a good match for you.

As the chart above shows, the value-investing approach works best for those who have limited time horizon, i.e. they plan on spending their invested capital soon, want an income stream from dividends, are risk-averse, and would rather not closely track their portfolios.

You don't have to be this kind of person in order to buy value stocks, of course; the strategy can work for everyone, as Buffett's immense success has shown. For example, one of his best investments in recent years came when he bought $5 billion worth of preferred stock in Bank of America in 2011 with a 6% dividend and also acquired stock warrants to purchase 700 million shares of Bank of America's common stock at a price of $7.14. At the time, the bank was still recovering from the financial crisis, but the stock has since surged, prompting Buffett in 2017 to exchange his preferred stake for 700 million common shares. Today, he's sitting on a gain of more than $14 billion. 

If you do have a longer time horizon though, it's a good idea to put at least a few growth stocks in your portfolio as the opportunity of avoiding them can be enormous. Even Buffett learned that the hard way by passing on opportunities to invest in Amazon and Alphabet, which he later said he regretted.

In investing, a central dilemma is that the perfect is often the enemy of the good. No investor gets the best possible returns available from the market or times their buying and selling perfectly, and, crucially, value investing does not promise to do this. But as investing icons like Graham and Buffett have shown, value investing, when done correctly, is undeniably a smart way to invest. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.