A sound investment strategy is value investing, where investors aim to buy stocks, bonds, real estate, and other assets for less than they are worth.
Selecting stocks could be difficult because the market overreacts to good and bad news, so the stock price movements won’t reflect the company’s long-term perspectives.
What is value investing?
There are two primary concepts regarding value investing, i.e. undervaluation and overvaluation. When a stock trades at less than its intrinsic value, it is considered an undervalued stock.
And on the other hand, when a stock is trading at more than its intrinsic value, it is considered overvalued.
Value investing is simply buying securities at a discounted price.
The commodity is for sale because its demand may not be high at that time. You save money by buying at a low price. Stocks, like any other commodity you buy, go through periods of low and high demand.
As a result, the value of stocks tends to fluctuate. This does not change the value you get for your money. Price, low or high, is just a mere reflection of demand, nothing more.
However, value investing means savvy value investors get the most out of stocks by buying them at low prices.
Value investors hold onto them because they are in the process of making long-term profits, and they make a killing when these stocks go up. Technically, buying the securities below their intrinsic value.
Additional read: What are goal-based savings?
How to calculate Intrinsic value?
There are various methods to calculate the intrinsic value of a company. Fundamentally speaking, a company’s intrinsic value is calculated by determining the present value of the company’s future cash flows.
It requires projected future cash flows and rate of return to determine the intrinsic value of future cash flows.
Let’s see some methods to calculate the Intrinsic Value of a company.
1. Price-to-Book Ratio
Price to Book, or P/B ratio, compares a company’s stock price to its book value per share. Book value per share of a company is the company’s net worth (assets minus liabilities) divided by the number of shares outstanding.
In some cases, investors exclude certain intangible assets (e.g. goodwill) from the calculation of the PB ratio.
In theory, any value below 1.0 means that the company’s stock is selling for less than the company’s net worth. Today, some banks are trading below their book value, while some growth companies are trading at multiples of their net worth.
2. Price-to-Earnings Ratio
The price-to-earnings, or P/E ratio, compares a company’s stock price to its annual earnings. For example, a P/E ratio of 15 suggests that at the company’s current earnings, it will take 15 years to break even in the share price.
Advantages of Value Investing
- Sustainable returns: Value investing could provide more than average returns in the long-term if done accurately. And these provide consistent returns over a longer period.
- Minimized risk: Value stocks have low volatility compared to growth stocks. Low volatility provides better risk-adjusted returns.
3. Value investing with mutual funds
Mutual funds offer investors the opportunity to invest in value-driven stocks. Most large funds offer both actively managed and passively managed (i.e. index funds) value funds.
For example, the ICICI Prudential Value Discovery Fund invests in value companies. A simple comparison of this fund can be made with the PGIM India Flexi Cap Fund.
Conclusion
Evaluating companies on the basis of value buying should not be the only criteria. Value investing is a prudent approach for value investors, and mutual funds offer funds that invest in value-driven companies.
