Value investing is an investment strategy taken up by investors who feel that a security, such as a stock, is trading lower than its book value and will increase in price over time. The Indian stock market is extensive and contains thousands of securities, and investors choose different investment strategies to make investments based on their risk appetite, investment goals, and time horizon. Among numerous investment strategies you can try, value investing is considered one of the most low-risk and has high return potential.
This blog will help you understand what value investing is and how it can help you build wealth over time and achieve your long-term goals.
What is value investing?
Value investing meaning refers to an investment strategy where investors identify and analyse stocks based on whether they are undervalued or overvalued. Undervalued stocks are those that are trading at a lower price than their book value, while overvalued stocks are those that are trading above their book value. Value investors invest in stocks that are undervalued as they believe that such stocks will increase in price over time to reach their actual book value.
The main idea behind value investing is to invest and forget. This means that value investors choose stocks to invest in for the long term because they believe they can earn significant returns through capital appreciation and regular dividend payouts.
Example of value investing
Here is an example for a better understanding of value investing’s meaning:
Imagine an investor who finds a business that consistently generates high profits, has a solid balance sheet, and has a low price-to-earnings (P/E) ratio compared to its industry. The stock price may be low despite its strong fundamentals because of recent market volatility or unfavourable sentiment.
In the hope that the market will eventually realise the company's true value, which will raise the stock price and result in a sizable return on investment, the value investor purchases the stock at this lower price. This strategy necessitates patience and a long-term outlook because the market frequently takes time to correct undervaluations.
Key takeaways
- Value investing is the process of identifying and investing undervalued stocks that are trading at a market price that is lower than their intrinsic value.
- Value investors include investing for the long term, generally for a minimum period of 1 year.
- Value investing utilises fundamental analysis to understand the company's financial performance rather than relying on technical analysis.
How does value investing work?
Value investing works on the principle of undervaluation and overvaluation. Value investors believe that undervalued stocks will rise in price to reach their actual book value sooner or later, while overvalued stocks will fall in price to reach their lower book value. Hence, value investing includes investing in undervalued stocks that have a high growth potential for the long term rather than investing for short-term gains.
Value investing involves analysing stocks based on their fundamentals rather than technical factors. Fundamental analysis provides insights into a stock's long-term performance, while technical analysis provides insights into a stock’s short-term performance. Value investing also includes the idea that a stock may perform negatively in the short term but can steadily increase in price in the long term to reach its actual book value.
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Advantages of value investing
Here are the advantages investors can enjoy if they include value investing as their investing strategy:
1. Risk minimisation
Value investing minimises the risk of potential losses by a hefty margin. Value investors invest for the long term based on a stock's good fundamentals. A stock with good fundamentals trading at a lower price than its book value has a high chance of increasing in price in the future. Although short-term traders may sell some of the stock, which can lower its price, the stock is likely to rise steadily over time to reach its intrinsic or book value.
The steady rise in price allows value investors who invest for the long term to reduce the associated risk, as they are not looking to sell in the short term. Since the investments are for the long term, they do not have to realise losses by selling the stocks at a lower price. This minimises risks for the investors and lets them earn through capital appreciation or dividends over time.
2. Substantial returns
Value investing is considered to be the most rewarding for investors as it can fetch substantial returns. For example, if a stock with an intrinsic value of Rs. 250 has reached Rs. 100 from Rs. 80 in two weeks, it has the potential to reach Rs. 250 sooner or later. Although you may earn Rs. 20 profit if you have bought the stock at Rs. 80 and sell at Rs. 100, a value investor waiting for it to reach its book value of Rs. 250 will earn substantially more in the long term.
Hence, value investing allows investors to earn better returns than traders who invest in the same stock to earn short-term gains. Furthermore, they also limit the margin of their losses, if any. This is also because value investors employ a margin of safety, where they invest in stocks that are trading lower than a particular limit. Even if the stock turns negative due to any unforeseen factor, the losses are limited.
Strategies for value investing
Now that you know what value investing is, you should understand the strategies included in the process of value investing. These are:
1. Fundamental analysis
This involves extensively analysing the company's financial statements, such as its balance sheet, income statement, and cash flow statement. Value investors look for companies with strong financial performance, low debt levels, and positive cash flows.
2. The margin of safety
Value investing includes buying stocks that are trading significantly below their book value, ensuring that investors can limit their losses in case of unforeseen market downturns.
3. Long-term investing
One of the most crucial value investing strategies is investing for the long term. Value investors hold stocks for several years, waiting for the stock to tackle the short-term market volatility and reach its true book value.
How do investors derive intrinsic value?
Value investors analyse if the stock is undervalued or overvalued based on the following metrics:
1. EBITDA (Earnings before interest, tax, depreciation, and amortisation)
EBITDA is the measure of a company’s overall financial performance and how much it has earned before interest, tax, depreciation, and amortisation. Companies with high EBITDA are considered fundamentally strong.
2. Discounted cash flow
Discounted cash flow (DCF) calculates a company’s book value based on its expected future cash flows. The method used to calculate DCF is discounted rate accounting. DCF also helps investors understand the company's future potential.
3. P/E (Price-to-earnings ratio)
The P/E ratio is a valuation ratio of a company's current share price compared to its per-share earnings. It indicates how much investors are willing to pay per rupee of earnings. A company with a lower P/E ratio is considered fundamentally strong.
4. P/B (Price-to-book ratio)
One of the most crucial ratios, it compares a company’s current market value to its book value. A company with a lower P/B ratio is considered fundamentally strong.
Disadvantages of value investing
Here are some disadvantages of value investing:
1. Long-term investment option
Value investing involves investing for the long term and not focusing on short-term gains. Hence, investors who want to invest for the short term can not adopt this strategy. Furthermore, value investing results in capital lock-up, where investors can not sell their stocks for a considerable period.
2. Time-consuming
Value investing demands identifying a number of stocks and analysing all of them on multiple ratios such as EBIT, EBITDA, P/E, and P/B ratios. The extensive analysis takes a significant amount of time and effort on the investors’ part.
Difference between value investing and growth investing
Here is a detailed table to understand the difference between value investing and growth investing:
Aspect |
Value investing |
Growth investing |
Investment philosophy |
Investing in undervalued stocks trading at a lower value than their book value |
Investing in stocks with high potential for future growth |
Market sentiment |
Stocks are overlooked or in less demand |
Popular stocks with high demand |
Rick level |
Generally lower risk |
Generally higher risk |
Investment horizon |
Long-term |
Long-term, but can also include shorter horizons |
Calculation metrics |
EBIT, EBITDA, discounted cash flow, P/B ratio, P/E ratio |
Earnings per share (EPS) growth, revenue growth, profit margins |
Stock price movement |
Steady capital appreciation |
Rapid price increases, but can also experience sharp declines |
Investor type |
Conservative, risk-averse investors |
Aggressive, risk-tolerant investors |
Is value investing right for you?
Value investing is ideal for investors who want to keep their investment risk at a minimum and earn steadily over time through capital appreciation and dividends. Investors who save an adequate amount every month and do not look to book profits for personal use from their investments are ideally matched with value investing as an investment strategy.
Furthermore, value investing is a long-term practice and requires investors to be patient and not sell their investments in the short term, even if they can earn significant profits. Hence, investors who are willing to spend time and effort to identify undervalued stocks and invest in them for the long term find value investing as the right investment strategy.
Summary
Value investing is an ideal investment strategy that requires investors to identify undervalued stocks by analysing them based on their fundamentals. Value investors invest in stocks that are trading below their book value, believing that every stock reaches its true book value sooner or later. For that, value investing requires long-term investment and value investors need to be patient. However, value investing also includes diversifying the investments across various investment instruments, such as mutual fund schemes.
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