By Arjun Chandrasekar.
Overview
Warren Buffett once said “Price is what you pay. Value is what you get.” Finding value in the assets we buy is common for pretty much everyone. We look for value discounts when buying groceries, ordering food, shopping for clothes, etc. Similar to this, the idea of value investing is to find stocks on a “discount”, or stocks at prices lower than their intrinsic value. This approach is meant to beat the market, where the market in a sense underestimates the true value of the stock. But it can be quite hard to find value stocks without truly knowing what to look for, and what conditions affect the market. So today, we’ll cover what exactly the strategy of value investing is, the metrics to analyze, and how certain uncontrollable factors can influence the market and stock prices.
Strategy & Metrics
Value investing is essentially finding discounts on stocks. To find these discounts, investors will analyze certain financial analysis metrics and compare them to the normal standards to figure out if the stock is valued lower or higher than its intrinsic value. The most popular metrics include price-to-book ratio, price-to-earnings ratio, and debt-to-equity ratio.
*Note: You can find the calculation values on Yahoo Finance.
Price-to-book, P/B, is basically used to find the “book” value of a stock and then compare it to the stock price. To calculate P/B, divide the stock price per share by the book value per share. Generally speaking, if the P/B value is lower than the stock price, the stock will be undervalued, and vice-versa for overvalued. As a value investor, you want to see an undervalued stock price because it means that you won’t have to overpay for your shares of the stock.
Price-to-earnings, P/E, is a demonstration of a company’s stock earning record. To calculate this, just divide the share price by the earnings per price. The result of the calculation will tell you whether the stock is undervalued or overvalued. Generally speaking, lower P/E ratios are signs of a good investment.
Debt-to-equity, D/E, is the relationship between the company’s shareholder equity and the company’s debt. You can calculate this by dividing total liabilities by shareholder equity. A good result would be in the margins of 1 to 1.5, and it will indicate whether a company uses its debt to fund its financial growth or not. Usually larger companies have bigger D/E ratios because they are classified as “capital intensive”, meaning they pool excessive amounts of money to fund their grand operations.
How is the Market Influenced?
Many factors play a significant role in influencing the stock market, and these factors thereby change stock prices. The most common ones include politics and media, economic instability, and the bandwagon effect. Politics and media are the most common influencers. Big news media can literally portray anything however they want to, and this can influence the masses. For example, if CNN broadcasts a news report saying “buy Gamestop”, thousands of people will probably buy Gamestop. This will cause a significant change in Gamestop price, and it will fluctuate a ton. This makes it very difficult for value investors to find the intrinsic value and carry out their normal calculations. Also, economic instability is a common change factor. How the economy functions on a day-to-day basis is sometimes unpredictable, where one day economic growth is high, another day it can be at an all time low. This can induce heavy swifts in the market similar to widespread politics and media. Finally, the bandwagon effect. This is essentially a media-type strategy, where the masses notice for example that investing in one stock is making a lot of money for a few individuals, so they all decide to invest in that one stock. This will again cause massive fluctuation in that one stock’s price, which is bad for value investors. So value investors should always be weary of these 3 influences and take them into consideration when performing their financial analysis.
Conclusion
To recap, value investing is a strategy game which requires a lot of patience, diligence, and mindfulness. The idea of it is to compare stocks’ price to their intrinsic value to see whether they are undervalued or on “discount” or not. Finding value is common in everyday life, and the same applies for investing in the stock market. If performed right, value investing can lead to making big bucks, like the multi-billionaire himself Warren Buffet.
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