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What is Value Investing?
Feb 07, 2024
| Views 354
Do you see yourself as a defensive investor without risk tolerance? If yes, a decent value stock offers protection against money loss and the potential to cash in after the stock market recognises the true value of the stock. So, what do you know about value investing? Let’s read on to learn further details on it.
What is Value Investing?
Value investing is an effective investment strategy, which includes choosing stocks that are underpriced or appear for less than the intrinsic or book value. Value investing includes two prime concepts –overvaluation and undervaluation. Value investors consider the stock to be undervalued when it comes to trading at a lower price than the intrinsic value. On the contrary, if the stock trades at a price higher than the inherent value, investors may choose the stock that is to be overvalued.
How Does Value Investing Work?
After learning the meaning of value investing, you now need to discover how it works. The main objective behind value investing is purchasing stocks when they are on sale. They sell them when they reach the intrinsic or true value or rise above the value.
Another condition the value investors follow is to allow for a safety margin while trading in value-investing stocks. In general, share prices may change due to different reasons, underlined by the popularised market tendency. It may cause a share's price to waver from its intrinsic value.
Value investors want companies that bring long-term potential and temporary downtrends in prices. These investors examine different parameters and determine the right company that performs based on the market capacity.
How to Derive Intrinsic Value?
When searching for an ideal value stock, you need to consider a wide range of fields to determine the value. That might include an individual’s financial history, revenues, cash flows, business models, future profitability, and profits. You can also investigate the reasons behind a company’s stocks being undervalued.
You also need to assess some indicators that offer insight into the company’s stocks and whether they are overvalued or undervalued. Some of the parameters are a company’s credit rating and debt clearing capacities, indulgence in the scam, and loss/profit during the last market recession.
The value investor analyses myriad metrics regarding the company’s underlying issues, such as:
EBIT
EBIT determines the establishment’s total cash flow without any impact on profits or secondary expenses. Taxation holds paramount importance here because the laws allow for some phenomena that mask a company’s real earning potential.
For example, an establishment may suffer financial losses initially. However, if it implements a strong strategy, it will eventually generate profits during operations. According to tax laws, organisations must deal with losses in the following years to set them against future profits.
A company can build a strong strategy to set up against future profits. Hence, taxation helps to determine the intrinsic value of the company.
EBITDA
The next comes EBITDA, or Earnings before Interest, Taxes, Depreciation, and Amortisation. Here, earnings are calculated without depreciation & amortisation expenses.
Discounted cash flow analysis happens to be a crucial metric that lets investors plan for a company’s future cash flows and find current value. It uses discounted rate accounting in case the price level rises. The fact is that investors can use the strategy to determine a company’s present value and future profits.
P/E Ratio
The price-to-earnings ratio signifies the connection between an establishment’s share prices and the per-share earnings. Suppose the company shares are Rs. 100 in the market, and the EPS is Rs. 18. Then, the P/E ratio is (100/18), or 5.55.
Investors must determine the metric as it signifies the amount they need to invest in a company to earn one rupee of the earnings
P/B Ratio
Another important consideration is the price-to-book value ratio or P/B ratio, which signifies the per-unit book value of the organisation’s assets and the price of the per unit share. For a company, the former is derived by dividing the total book value of an establishment’s assets by the outstanding shares’ market value.
Suppose the share prices of the company are lower than the value of per unit book. In such cases, it denotes that the stocks are undervalued. It indicates that the company possesses the required capacity to earn some profits in the future. It also indicates that it is experiencing a short-term financial crisis.
Advantages of Value Investing
Value investing comes with various advantages. From minimising risks to offering substantial returns, it offers multiple benefits. Investing in equity shares comes with high risks as it corresponds with market fluctuations.
In general, investing in equity shares is associated with high risk due to its correspondence with market fluctuations. But value investing gives investors a chance to mitigate risks by earmarking undervalued stocks.
One can buy shares on sale. Eventually, such shares reach the intrinsic prices or, at times, may go higher. This allows them to earn capital gains.
Additionally, investors can reduce the related risk with a margin of safety. It refers to buying a share at a discount to a specified price. Thus, damages, if any, would not be substantial regardless of whether they were mistaken about a particular firm.
If managed correctly, value investment may yield returns that are higher than average in the long run. It's because, as was previously explained, investors utilise a margin of safety.
Suppose an investor buys a company's shares for Rs. 70 per share. Consider the intrinsic value of Rs. 100 per share. So, the investor sells the shares as soon as the stock recovers to the inherent value. Now, the investor can make an additional profit of Rs. 30 per share when share prices rise above the intrinsic value.
Top Value Investing Strategies to Consider
An investor needs to consider these strategies:
â—Ź Invest in an establishment you understand
â—Ź Look for well-managed companies
â—Ź You don’t necessarily have to go with the market trends every time
Wrapping up
The only downside of value investing is that you won’t get high returns in the short term. So, it locks in the investor’s cash for a long time. Whether done offline or online, value investing takes a lot of time as investors are required to actively look through quantitative and qualitative data sets to identify the undervalued companies.
Note: The information herein is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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