Many investors use some tool or strategy to pick stocks for investing. Value investing is one such approach where the buyer actively seeks undervalued stocks. This approach requires a thorough understanding of the market.
Value investing is an age-old strategy popularised by Benjamin Graham, who was a mentor to Warren Buffett. Buffett, a billionaire investor and a trailblazer, is one of the most famous proponents of value investing.
Value investing focuses on the concept of intrinsic value to pick which stocks to buy. Value investors believe that all stocks have real or intrinsic value that may be different from their market value. Undervalued stocks trade below their intrinsic value, while overvalued stocks trade above their intrinsic value.
How to do value investing?
If you want to invest in the share market using value investing, you need to look for undervalued stocks.
Example A: A share is trading at Rs. 150; however, you feel its real value as per your analysis is Rs. 200. You buy that share as it is undervalued. You wait for the share to reach its true value (Rs. 200) and then sell it at a profit.
How can you use this value investing strategy to invest in stock market today? You look for the following aspects:
- Debt to Current Asset ratio
Look for stocks that have a low debt load. As per Benjamin Graham, this ratio should be less than 1.1.0.
- Current ratio
The current ratio is current assets divided by current liabilities; find companies with a ratio over 1.50.
3. Earnings Per Share (EPS) growth
Pick companies with positive EPS growth in the past five years with no earnings deficits.
4. Price to Earnings Per Share ratio
Another criterion to invest in the stock market is the PE ratio. Find companies with P/E ratios of 9.0 or less.
5. Price to Book Value ratio
A price to book value (P/BV) ratio of less than 1.20 is a good indicator.
When you invest in an undervalued company, you may have to wait for a while for the stock price to reach its true potential. In the meanwhile, you can collect dividends and earn some returns on your investment.
7. Quality rating
When looking for a stock to invest in, look for a quality rating that is average or better. You don’t have to find the best quality companies.
As per Warren Buffett, you should avoid the herd mentality. He once famously said, “Be greedy when others are fearful and be fearful when the others are greedy.”
Remember to keep a safety margin when you look for stocks to buy today. In the above Example A, your margin of safety is Rs. 50 (Rs. 200 – Rs. 150).
Benefits of value investing
● An advantage of value investing is that you identify securities that have good potential and are undervalued in the stock market today.
● Another advantage is that it is an investment backed by facts. You pick stocks after looking at various ratios, numbers and other factors.
Drawbacks of value investing
● Investing in undervalued stocks tends to be risky as any miscalculation may result in heavy losses.
● Undervalued stocks may take years to reach their intrinsic value, and they may never reach their full potential.
Take the right step towards investing
The case of Warren Buffett is one of the popular ones who gained unparalleled success while opting for value investing. If you are interested in investing in stock market but don’t have the time or the resources to delve deep into these concepts, it is prudent to reach out to a financial expert to guide you.