The answer to the question “What is value investing” is quite simple. It’s just a matter of finding stocks that are not being appropriately valued by the markets. The growth sell-off and other recent market trends have made value investing more popular than it’s been in years.
Sometimes factors can cause a stock to get beaten down to the point of being undervalued. Value investing is about finding stocks that are worth more than their current share price.
Investment legends like Sir John Templeton, Benjamin Graham and Warren Buffett realized decades before behavioral finance became a respected academic discipline that systematic psychological errors tend to create market inefficiencies.
Templeton, Graham and Buffett reasoned that herding behavior (including momentum traders and short-term speculators that chase price trends) and overreaction bias (the tendency of people to overreact to bad news) are strong forces in the market that can push stocks far below their fair value.
Based on these observations, many of the world’s greatest investors look for stocks that are beaten down by the market due to bad news or negative rumors.
Benjamin Graham, the father of value investing, constantly searched for companies that once fetched sky-high valuations but that crashed when the companies were unable to deliver on investors’ expectations.
Warren Buffett famously said, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
Value investing is about recognizing opportunities and spotting deep discounts. One way some investors measure a company’s value is its price-to-earnings ratio, or P/E. But P/E is a very simplistic measure of a stock’s value.
Experts dig deeper, examining a company’s sales, cash flow, dividend, book value, debt levels, historical valuation patterns and more to determine if a stock is undervalued.
Benjamin Graham’s Value Investing Criteria
Benjamin Graham actually established a method for value investing in his world famous book, “The Intelligent Investor.” Graham’s method consists of seven factors that help investors identify value stocks. Your broker likely offers tools to allow you to screen for these factors, but you can also use a tool like finviz’s screener to capture many of these metrics.
The first factor is quality rating. This helps to identify good companies to invest in while weeding out the sub-par competitors. Graham actually favored using the S&P Quality Ranking (formerly the Earnings and Dividend Rating) and recommended only investing in companies with a B rating or higher.
The second factor identified is total debt to current asset ratio. You don’t want to be committed to an investment in a company which is saddled with burdensome debt. So, for that reason Graham recommended only investing in companies with a total debt to current asset ratio of less than 1.10.
The third component Graham considered was current ratio. He recommended searching for companies with current ratios upwards of 1.50.
Fourth, you want to ensure that the company you might invest in has experienced positive earnings per share growth over the past five years. While doing this, avoid companies that have earnings deficits as they have proven to be somewhat volatile in the past.
Fifth, identify companies that possess price to earnings per share (P/E) ratios of less than 9.0. Doing this will help you to exclude growth stocks and focus on value stocks.
The sixth component to consider is price to book value (P/BV) ratios. Companies with P/BV ratios of less than 1.20 are worth investing in. This gives you a sense of the underlying value of the company and if their stocks are trading around the book value of the company, they might be a good investment.
Finally, you want to search for companies that pay dividends. It may take a while for other investors to realize the potential of the undervalued stock you invested in. However, if you invest in a company that pays dividends, you will at least be drawing some income until other investors realize the opportunity they are missing out on.
Does this answer your question of what is value investing? If not, what else would you like to know?
*This post has been updated from a version published in 2019.