Value investing is the art of finding stocks that trade for a discount relative to their true, or intrinsic, value. This concept is easy to understand, but in practice, finding undervalued stocks can be very hard to do. After all, if a company is obviously undervalued, everyone would buy it, the price would rise, and it would no longer be undervalued.
So, to be a truly effective value investor, you'll need to find the value stocks that are trading for bargain valuations that few other people know about. To do this, you'll first need to familiarize yourself with some important value investing concepts and some essential investment metrics. You'll also need to develop your own system of analyzing stocks and finding those that trade for less than they're truly worth.
With that in mind, here's a rundown of what you should know before you get started, so you can invest in value stocks the right way and find overlooked bargain opportunities of your own.
What is a value stock?
Stocks can be generally classified into one of two categories -- value stocks or growth stocks. Value stocks are loosely defined as companies that trade for valuations that are below the overall stock market average. Typically, value stocks are long-established companies with consistent profitability, stable revenue streams, and slow but steady growth. Most (but not all) value stocks pay dividends, and traditional investing metrics like the P/E ratio and book value calculations generally translate well to value stocks.
On the other hand, growth stocks are loosely defined as those of companies that are growing revenue faster than the stock market average. These are generally stocks in the early stages of growth or established companies whose revenue continues to grow at a consistently high rate. Growth stocks are less likely to pay dividends, and traditional investment metrics often don't apply well to growth stocks.
As you might imagine, there is some gray area here, and it's entirely possible for a stock to fit in both categories. For example, some growth stock ETFs like the Vanguard Growth ETF (NYSEMKT:VUG) own shares of Apple, while at the same time, the tech giant is a top holding of some value ETFs like the iShares S&P 500 Value ETF (NYSEMKT:IVE). This certainly makes sense -- Apple is undervalued when compared with the rest of the market based on several valuation metrics, and many aspects of the company's business are growing at rapid rates.
Here's one key point to understand before we move on. Despite the implication of the word "value," not all value stocks are necessarily good investments.
For example, there's type of stock known as a "value trap" that looks like a cheap stock, but it's cheap for a reason. It's certainly a good idea for investors to learn the value trap red flags to look for, such as a too-good-to-be-true dividend yield (also known as a yield trap) or a P/E ratio that looks like an incredible bargain relative to peers.
To be perfectly clear, value stocks are a category of stocks that have certain characteristics. Value investing is the practice of trying to find the best opportunities among value stocks.
The main goal of value investing
The point of value investing is to find stocks that are trading for a discount to the true value of their business. In other words, a value investor might aim to purchase shares of a company for $0.90 for every $1 of value they represent. The idea here is that eventually the market will realize the true value of these companies, and this will send their stock prices higher at a faster rate than the overall stock market.
Essentially, a value investor wants to buy $100 bills that are accidentally being sold for significantly less than $100.
This sounds like a simple enough concept, but it is easier said than done. After all, if someone was obviously selling $100 bills for $80, the bargain wouldn't exist for too long. You need to find the $100 bills that are being sold cheaply that few other people know about. In order to effectively evaluate value stocks and find the bargains most people are overlooking, you'll need to familiarize yourself with some important investing concepts, learn some investing metrics, and be prepared to spend significant time learning how to apply these concepts and metrics toward evaluating stocks in the real world.
Important value investing concepts
Before you get started with value investing, there are some important concepts to understand. Here's a quick guide to some of the terms you should know before you start evaluating value stocks to invest in.
This is the central concept of value investing and is also the most difficult to define. Intrinsic value refers to the true value of a business, but there's no one way to determine this. In other words, if you asked 10 highly experienced value stock analysts to calculate the intrinsic value of a company, you're likely to get 10 different answers. The way to become successful as a value investor is to develop your own effective way to calculate the intrinsic value of a business.
Margin of safety
One thing value investors often look for is known as a margin of safety, or something that should limit the investor's potential for losses. This can be as simple as finding a company that trades for a big discount to its book value or that pays a rock-solid dividend that is well above average. For example, if you are analyzing a real estate investment trust, or REIT, whose properties have a fair market value of $1 billion net of debt, there's a considerable margin of safety if the company's market capitalization is just $750 million. Legendary value investor and Berkshire Hathaway CEO Warren Buffett once gave an excellent description that conveys the importance of looking for a margin of safety:
On the margin of safety, which means, don't try and drive a 9,800-pound truck over a bridge that says it's, you know, capacity: 10,000 pounds. But go down the road a little bit and find one that says, capacity: 15,000 pounds.
This is a concept that was popularized by Warren Buffett and refers to a company having some sort of durable competitive advantage, which can help protect its market share and profitability over time. Just to name one example, Coca-Cola (NYSE:KO) has the advantage of a massive distribution network and valuable brand name, the combination of which allows the company to move its products around the world more efficiently than competitors and charge a higher price than those competitors. Economic moats can come in the form of cost advantages, brand names, having an ecosystem of products, or high switching costs for consumers, just to name a few possibilities.
A company's book value is defined as the value of its assets minus its liabilities and can be easily calculated by finding these two numbers on the company's balance sheet. You can also calculate book value on a per-share basis by dividing this number by the number of outstanding shares a company has. This is a very important concept for value investors, as finding stocks that trade for less than the value of the assets they represent can be a good way to find underpriced companies.
Tangible book value
This is similar in concept to book value but it excludes intangible assets such as goodwill and intellectual property rights. From a value investing standpoint, this can be used to incorporate a margin of safety when determining the true value of a company's assets -- after all, it's difficult to tell how much things like intellectual property might sell for in a liquidation.
A company's cash flow is defined simply as the difference between the cash that flows into the company's accounts and the cash that flows out. If a company takes in $50 million during a particular quarter and spends $30 million on investments in equipment, paying dividends, etc., it would have cash flow of $20 million. Publicly traded companies release a cash flow statement along with each quarterly report, and toward the bottom you can find the change in the company's cash, which is the overall cash flow for the reporting period.
This stands for earnings before interest, taxes, depreciation, and amortization. EBITDA is used in several value investing metrics, as it is thought to give a more apples-to-apples version of "earnings" than net income. For example, real estate companies are entitled to lots of depreciation deductions, which reduce net income even though it doesn't actually cost anything. EBITDA can help account for distortions like this.
Free cash flow
A company's operating cash flow minus its capital expenditures is defined as free cash flow. For example, if a company's operating activities generate net cash of $40 million and the company spent $10 million on new equipment, it would have free cash flow of $30 million.
This is a metric that helps investors evaluate the stability and sustainability of a company's dividend. Payout ratio is the percentage of a company's earnings it pays out to shareholders as dividends. For example, if a certain company earned $1.00 per share in 2018 and paid out $0.40 per share in dividends, it would have a payout ratio of 40%. While there's no particular definition of a high payout ratio, you obviously want to see that a company is earning more than enough money to continue paying (and hopefully increasing) its dividend. And this can be useful for comparing the safety and sustainability of the dividends paid by several different companies.
Discounted cash flow
The mathematics of discounted cash flow analysis are beyond the scope of this article, but this is still an important concept to mention in a discussion of value investing. The basic idea is that this allows investors to determine the future value of an established company's cash flows -- in other words, taking inflation into account in order to figure out how much the company's future cash flow is worth today.
5 value investing metrics to know
The next step is to learn some of the most useful value investing metrics to compare stocks. In no particular order, here are five that you'll probably use regularly in your analysis.
Price-to-earnings (P/E) ratio
This is perhaps the most widely used metric in investing, but the price-to-earnings, or P/E ratio is still an important one to discuss. By dividing a company's share price by its annual earnings, we can get a good basis for comparing it with companies with similar businesses and growth rates. Two commonly used versions of this metric involve the company's last 12 months of earnings (known as trailing 12 months, or TTM earnings) or the company's next 12 months of projected earnings (known as forward earnings).
Price-to-earnings growth (PEG) ratio
The PEG ratio is often thought of as a growth investing metric but can also be useful for value investors. In a nutshell, the PEG ratio provides an apples-to-apples comparison method for companies that are growing at different rates. If one value stock is growing earnings at a 9% annualized pace while another is growing at 5%, the PEG can help you take this into account. To calculate the PEG ratio, simply divide the company's P/E ratio by its annualized earnings growth rate. (Note: Unless a company is growing its earnings at a substantial rate -- say, 5% or more -- the PEG ratio isn't particularly useful.)
Cash flow multiple
Traditional calculations of earnings don't always tell the whole story of how a company is doing. There are companies that have seemingly low "earnings" despite being highly profitable on a cash flow basis (real estate is a good example), while others can have deceptively high earnings. By using a company's cash flow multiple, which is also referred to as the price-to-cash flow ratio or EBITDA multiple, you can have another metric to use that can clear up any distortion that exists in a company's reported earnings.
Debt to EBITDA
If a company has high debt, it can cause the market to value it more cheaply than companies with relatively low debt. However, debt that is too high can be a cause for concern. So, it makes sense to incorporate a debt metric into your analysis, and the debt-to-EBITDA ratio is one of the most effective and also is one of the easiest to calculate.
Price-to-book ratio (P/B)
A company's book value is what would (theoretically) be left if a company closed its doors, ceased operations, paid off its debts, and sold its assets. In other words, the value of a company's equipment, buildings, and the rest of its business assets is known as its "book value." Calculating a company's share price as a multiple of its book value can be a good way to compare how expensive or inexpensive companies in the same industry are trading for. Taking it a step further, you can also use the company's tangible book value in the calculation -- this excludes things like goodwill and intellectual property. Finding companies that trade for less than book or tangible book value but that otherwise have strong business fundamentals is one of the most commonly used value investing methods.
Read some great value investing books
As much as I'd like to, there's no way I can thoroughly explain how to evaluate the intrinsic value of stocks in a few paragraphs, or even in an entire article. I can, however, recommend a couple of the best books ever written on value stock investing.
First, The Intelligent Investor by Benjamin Graham is often referred to as the best book ever written about value investing and is a cornerstone of the investment philosophies of Warren Buffett and several other successful value investors. It has in-depth yet understandable explanations of valuation methods to find cheap stocks.
Graham's other book, Securities Analysis, was actually written years before The Intelligent Investor, and while it is a somewhat more difficult read, it's a must-read for anyone who wants to thoroughly learn how to analyze value stocks. I've often said that The Intelligent Investor is "value investing 101" while Securities Analysis is graduate school for value investors.
In a nutshell, the information in this article will give you a great background when it comes to understanding some key concepts and metrics in value investing. Reading these books will give you the tools to effectively use them in real-world situations.
The bottom line on value stock investing
For the most part, value stocks are long-established companies that have steady (but not rapid) growth rates, stable revenue, and consistent profitability. Value stocks generally won't make you rich overnight -- and that's not the goal. If you've heard the expression "slow and steady wins the race," it is one of the best ways to summarize the strategy behind value investing.
Take legendary value investor Warren Buffett, for example. Buffett never buys stocks because he thinks their prices are going to rise this month or this year -- he buys stocks because he thinks the underlying business is worth more than he is paying, and he's willing to wait for years (or even decades) for the true value to be reflected in the stock price.
By learning to evaluate stocks like these, and to find those value stocks trading at a discount to their intrinsic value, you can give yourself an advantage when it comes to buy-and-hold investing. The idea is that over time, the market will naturally correct any mispricing. Stocks that you buy for less than they are truly "worth" will therefore appreciate faster than the overall market, producing superior long-term investing returns.
Some of the most successful investors in the world apply these value investing principles to their strategy, and you could use the same methods when constructing your portfolio.