What is Value Investing and How to Evaluate a Value Stock?

A few years ago sales and discounts used to be very time specific. Our parents would usually wait for Diwali sale or a new year sale to make purchases. value stocks But these days sales occur almost every month and discount have become very common. I don’t remember the last time I went to a shopping mall and didn’t come across a 40% off sale tag. But why do we keep hunting for discounts every time we make a purchase? It is because people love to buy things at discounted rates. Not only it saves money but you can buy more at a lower price. The simple reason why we get induced by sales is that we see value in buying something for cheap. Similar is the case with the stock markets. Sometimes stocks are also available at discount. Stocks that trade at a discount or are undervalued are known as value stocks. Value stocks have a high margin of safety. It refers to the difference between the intrinsic value of a share and the current price of a share. For instance it doesn’t matter if you buy a TV at a discount price or buy it at MRP. Its picture quality is going to remain the same. Likewise buying a stock at discount or at its true value the fundamentals of the company is going to be the same. So in value investing you aim to buy a high value stock for cheap. This theory was first proposed by Benjamin Graham and David Dodd in 1928. Both of them outlined the concept of value investing in their book Security Analysis. Later, Benjamin Graham explained the in-depth concept in his famous book The Intelligent Investor The legendary investor Warren Buffet was a student of Benjamin Graham at the Columbia University. Today he has mastered the art of value investing.

How does value investing work?

Value investing is a simple strategy. Let’s understand it with an example.  An investor finds stocks that are priced less than their intrinsic value which is the true valuation of a stock.  If you pick a value company with strong fundamentals, the market price will soon appreciate and meet its true price. This is how value investing works. Hence, greater the difference between the true value and market price, the greater profits you will make in the long term.

Why does the market undervalue a stock?

1. Market recessions

Generally, a stock is undervalued when there is bearish sentiment in the markets. A recent example of such situation was when COVID-19 hit the capital markets. Plenty of stocks were available at discount. At such times of uncertainty…investors dump a lot of stocks out of their portfolios due to fear of further losses. This can be a great opportunity to buy stocks which are undervalued.

2. News

Many a times market reacts to adverse news due to which the stock prices fall. Negative news will cause investors to sell a stock. The reasons behind this could be interest rate changes or sectorial uncertainty. In such situations the impact will be temporary. So, investors need to carefully analyse the impact of news on the share price and check if it’s worth investing.

3. Internal factors of the company

In the above two situations, the fundamentals of the company were more or less the same. But stock prices were affected by external factors. Even internal factors such as change in management, new product launch or mergers and acquisitions (M&A) can affect a stock’s price. For example: In September 2020, Domino’s Pizza introduced a new range of pizza’s titled Chef Boss. The stock price of Jubilant Foodworks saw a bullish trend after this.

How do you analyse a value stock?

1. Price to Book ratio is less than 1

Price to book ratio (PB) refers to the relation between the market price of a company’s outstanding shares and its book value. Stocks that have a PB ratio of less than 1 are considered value stocks. This means that the stock is trading at less than its book value.

2. High Price-Earnings to growth ratio (PEG ratio)

PEG ratio is a metric that helps investors know the true value of a stock by considering its current market price to its earnings and future growth prospects. PEG ratio is an improvement over the price to earnings (PE) ratio. While calculating PE, we don’t consider the growth rate of a company. The PEG ratio compares a company’s PE ratio to its expected growth rate. A high PEG ratio means that a stock price is expensive as compared to earnings and is overvalued. Conversely, a low PEG ratio indicates that the current value of a stock is cheaper as compared to its earnings.

3. Low Debt

A company which has high debt in its balance sheet can rarely create value in the future. As most of its earnings would be spent on repayment. A low debt ratio with steady growth in revenues and profits is one of the best indicators of an undervalued company.

4. A rise in revenue and earnings of the company

If a company is making huge profits, then the market will willingly appreciate the stock in the near future. To analyse this you need to carefully look at the balance sheet of the company. Or refer to the top line growth of the company. Top line growth is the company’s revenue. Consistent growth in revenue percentage can prove to be beneficial for an investor.

5. Discounted cash flow (DCF)

Discounted cash flow (DCF) is a valuation method which determines the expected future cash flow and finds its true value. If the current share price is more than the DCF value, then the stock is overvalued. If the current share price is less than the DCF value, then the stock is undervalued and can be a potentially rewarding investment.

Check out our video on how you identify the best value stocks to buy in India


Advantages of value investing

1. You get good business at a fair price

Investing in stocks that are currently undervalued will help earn higher returns in the future. Also these stocks are not popular in the market. Hence value investors can buy these stocks for a low price. You can have a look at the margin of safety and other ratios of each stock on Samco’s stock page

2. You can make huge profits because of compounding effects

Investing in value stocks is an ideal way to take advantage of the power of compounding. When you reinvest your returns and dividends it will compound and your profits will grow exponentially over time.

How to fit value stocks in your investment strategy?

Value investing is a long term investment strategy. Here you need to have patience and let the stock reach its intrinsic value. These stocks can be volatile in the short term but can become multibaggers in the long term. However, value stocks have risks of their own. It might happen that the stock you bought may never become appropriately valued. Or might even decrease from its current value. Hence, diversification is the best solution to protect yourself from such risks. Creating a well diversified portfolio can help you earn good returns with low risk. You can also invest in value mutual funds. It lets you invest in lots of value stocks at once.

Here is a list of best value mutual funds

Funds Rating 6 months 1 Year 3 Years 5 Years AUM (in Rs cr) Expense Ratio
Tata Equity P/e Fund Regular Plan Growth 5 star 20.91% 73.31% 5.79% 15.00% 4,553.04 1.97%
Uti Value Opportunities Fund-Growth Plan 4 star 31.29% 84.28% 12.10% 13.87% 5,441.13 1.9%
L&T India Value Fund - Growth 3 star 30.53% 95.05% 7.37% 14.11% 6,706.57 1.9%
HDFC Capital Builder Value Fund - Regular Plan 3 star 28.36% 85.40% 5.96% 12.63% 4,459.57 2.05%
Icici Prudential Value Discovery Fund-Growth 3 star 32.42% 89.90% 11.19% 12.67% 17,675.93 1.81%
Nippon India Value Fund-Growth Option 3 star 32.79% 90.05% 9.61% 14.58% 3,495.43 2.02%
Quantum Long Term Equity Value Fund 3 star 31.39% 87.96% 8.06%   - 41.93 1.79%
To conclude, while evaluating a value stock you must collect all the facts and figures of the company yourself and accordingly make a decision. It is important to thoroughly evaluate and carefully understand the quality of the business and management and its long term strength before you buy value stocks. You can explore more about the company’s fundamentals and ratios on Samco’s Stock page. It gives you complete information about the latest news, valuation analysis, financial performance and a lot more. So open a Free Demat account with Samco which is India’s best broker awarded by CNBC Awaaz and get access to the Samco App for free.

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