What is Value Investing?

There’s often a mismatch between the intrinsic value of an asset and the price at which it trades in the stock market. Investor sentiment and daily news tend to influence market prices, resulting in these fluctuations. Nevertheless, the intrinsic value of an asset is considered an important indicator of its future potential returns and underlying financial health.

This philosophy is at the heart of value investing, a discipline dedicated to identifying and potentially capitalising on the discrepancy between the two figures: true value and market price.

Table of contents

• What is value investing?
• The mechanics: How does value investing work?
• How investors determine intrinsic value
• Value investing vs. growth investing: A core distinction
• Advantages and disadvantages of the value approach
• Potential disadvantages and risks
• Is value investing suitable for you?

What is value investing?

Value investing is a methodical approach to the selection of equities that are fundamentally strong but seem to be trading at prices lower than their intrinsic value. A stock might be deemed undervalued if its market price is significantly lower than its determined intrinsic value.

A value investor attempts to ascertain the stock's intrinsic value by looking away from market noise that is influenced by emotions and overconfidence, and instead evaluating the stock’s fundamentals, such as company balance sheets, track record, management practices etc. (Past performance may or may not be sustained in future).

The value investing strategy involves purchasing these undervalued assets and holding them, often for relatively longer periods. The investment approach rests on the belief that the market will eventually recognise the company's true worth, potentially allowing the stock price to correct itself – though this is not guaranteed.

The mechanics: How does value investing work?

Value investing operates on the premise that markets are not always rational, leading to pricing discrepancies. This might create two scenarios for a given stock: overvaluation and undervaluation.

• Overvaluation: Occurs when factors such as investor enthusiasm, herd mentality, market speculation, or temporary strong performance may push a stock's price significantly above its fundamental, long-term potential worth.
• Undervaluation: Occurs when negative sentiment, a cyclical downturn, or market neglect pushes a stock's price significantly below its potential intrinsic worth.

With intricate evaluation of the company fundamentals, cash flows, governance, and business moats, an investor may be able to estimate the true value of the company. In cases where the market price trades below the intrinsic value, the investor could aim to build a position with a margin of safety, with the assumption that the market might eventually realise the intrinsic value of the stock and the price will correct itself.

Read Also: Value Investing vs Momentum Investing: Key Differences

How investors determine intrinsic value

Several methods are employed by investors to arrive at the intrinsic value.

1. Discounted cash flow (DCF) analysis—One of the most widely used, the DCF method of valuation, takes the company’s future cash flows into account for a specific period and then uses a discount rate to arrive at the present value.
2. Relative valuation metrics – A company is often valued by benchmarking various metrics against its competitors or its own historical data.
   1. Price-to-earnings (P/E) ratio – The relationship between the company’s market price and the earnings per share is used to check if a stock may be undervalued or overvalued. The P/E ratio measures how much investors are willing to pay for each rupee of a company's earnings. A higher P/E ratio may signal high expected growth – but it could also suggest overvaluation – whereas a low P/E could highlight that the company is available at a lower price compared to its peers in the industry, though it may indicate a weaker future outlook.
   2. Price-to-book (P/B) ratio – This ratio compares the company’s book value with the market price. A P/B ratio under 1 may signal undervaluation.
3. Earnings valuation – Often, investors consider EBIT (Earnings Before Interest and Taxes) or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation), which exclude depreciation/amortisation and/or interest & taxes, to approximate potential earnings, while being aware that these metrics don’t equal cash flow and require further adjustment.

Value investing vs. growth investing: A core distinction

Value investing is often contrasted with growth investing with respect to their fundamental approach towards stock selection. Growth investors look for companies with high future earnings potential and rapid growth numbers, even if it is at a relatively more expensive valuation.

Advantages and disadvantages of the value approach

Like any strategy, value investing carries both, benefits and risks.

Potential advantages and benefits

• Risk management: A margin of safety, which aims to cushion the impact of significant downturns, is one of the fundamentals of value investing.
• Return potential: If the market price of a stock rises to its intrinsic value over time, there is potential for long-term capital appreciation.
• Fundamental analysis: Value investors base their buy and sell decisions on tangible factors, metrics and business fundamentals, reducing the influence of speculation or emotion.

Potential disadvantages and risks

• The "value trap": A stock may appear cheap but could also be on the path to terminal decline––the company's technology may be obsolete, or its management may be inept. In this case, the ‘value’ may never materialise.
• Requires extreme patience: It could take years for the market to recognise an undervalued stock. During this time, the investor may have to endure periods of potential underperformance.
• Intensive research: Value investing may require a reasonable level of financial literacy and the time and effort to read annual reports, analyse financial statements, and understand complex business models.
• Psychological strain: Value investing goes against prevailing market sentiment. A value investor is, by definition, buying assets that the market may have ignored and priced low. This might require patience and emotional discipline to stay the course, over a long horizon.

Read Also: Growth vs Value Investing: Which One Should You Choose?

Is value investing suitable for you?

Some of the key requirements of value investing include:

• Long-term vision, a disciplined approach and the skill to ascertain the true potential value of a company.
• If you can hold on to your investments through periods of market volatility and maintain discipline despite emotional market reactions, value investing may potentially help in wealth creation over the long term.
• In contrast, investors who are uncomfortable with underperformance for extended periods or who are pursuing near-term goals may find the discipline and time requirement of value investing to be too restrictive.

Conclusion

Value investing is a philosophy built on prudence, analysis, and patience. While it focuses on a disciplined pursuit of value that may potentially support long-term financial goals, all investment strategies carry risks and returns are not guaranteed. Investors should consider their individual circumstances and risk tolerance before adopting any investment approach

FAQs

What is the core concept of value investing?

The core philosophy that value investors adhere to is the identification and purchase of discounted stocks that are trading below their intrinsic value but demonstrate strong fundamentals.

Can you provide a simple example of value investing?

Let’s assume a banking stock’s market price has fallen 30% due to a short-term rise in NPAs (Non-Performing Assets). If the fundamentals and financial standing of the bank show that it is potentially well placed to handle these losses and its long-term earnings potential remains positive, a value investor might invest in it, believing that the price will recover over the long-term after an overreaction to a momentary setback.

Example for illustrative purposes only.

What are the primary benefits of a value investing strategy?

Potential for long-term growth is one key benefit. Risk management is another -- value investors might be able to cushion against some potential losses because they’re already buying the stock at a relatively lower price, creating what is termed a ‘margin of safety’ (though this does not eliminate investment risk). Additionally, this method could also serve as a framework to build an investment discipline.

How does one begin value investing?

Value investors may consider learning to read financial statements (balance sheet, income statement, cash flow statement, etc.). Beginners could start by studying the principles of value investing and then analysing companies using common valuation metrics like P/E and P/B ratios before moving to more complex models like DCF.

Is value investing a profitable strategy?

Value investing may be a potentially suitable strategy if the market eventually recognises a stock’s intrinsic value and if the investor approaches it in a disciplined manner and with a long-term view. On the contrary, it might also underperform during certain periods based on market cycles.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

The content herein has been prepared on the basis of publicly available information believed to be reliable. However, Bajaj Finserv Asset Management Ltd. does not guarantee the accuracy of such information, assure its completeness or warrant such information will not be changed.The tax information (if any) in this article is based on current laws and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.