Financial Planning
What is Value Investing & how does it work?
Value investing is a strategy focused on buying securities that appear to be underpriced relative to their intrinsic value. This method, popularised by Benjamin Graham in the 1920s, encourages investors to identify and invest in stocks that the market has undervalued.
Meaning of value investing
What is value investing? It refers to purchasing shares or other assets that are trading below their intrinsic value. The idea is to find assets that the market has mispriced — those whose current prices do not reflect their actual worth based on the company’s fundamentals.
Key concepts in value investing
- Intrinsic value: This is the true worth of a stock, determined by analysing factors such as earnings, dividends, growth prospects and overall financial health.
- Undervaluation: When a stock is trading for less than its intrinsic value, it’s considered undervalued. Value investors seek out these opportunities to buy the stock at a discounted price.
- Overvaluation: If a stock’s market price exceeds its intrinsic value, it is considered overvalued, which may signal to value investors that it’s time to sell.
How does value investing work?
Value investing works by leveraging the difference between a stock’s current market price and its intrinsic value.
As a value investor, you use fundamental analysis to estimate the intrinsic value of a stock. You look at a company's financial statements, assess its management, and consider broader economic factors. If the stock’s market price is significantly lower than its intrinsic value, it becomes a potential investment.
For example, a stock may be trading at ₹80, but after a detailed analysis, you might determine that the stock’s intrinsic value is closer to ₹100. In this case, the stock would be considered undervalued. The idea is to buy undervalued stocks and hold them until their prices rise to reflect their true value.
Techniques to derive intrinsic value
Price-to-earnings ratio (P/E): This ratio compares a firm’s share price to its earnings per share (EPS). A low P/E ratio may indicate that a stock is undervalued relative to its earnings.
2. Price-to-book ratio (P/B): The P/B ratio compares a company’s stock price to its book value (i.e., its assets minus liabilities). A P/B ratio below 1.0 suggests that the stock might be undervalued.
3. Discounted cash flow analysis (DCF): This method calculates the present value of a company’s expected future cash flows, adjusted for inflation and other factors. It helps investors determine if the current stock price reflects the company's potential.
4. Earnings before interest, taxes, depreciation, and amortisation (EBITDA): EBITDA is a useful metric to evaluate a company’s operating performance. By excluding non-operating expenses, it gives a clearer picture of a company’s earning potential.
Advantages of value investing
- Mitigated risk: Value investing focuses on buying stocks that are trading below their intrinsic value, which provides a margin of safety. This approach helps limit potential losses even if the stock does not perform as expected, as the investment was made at a lower price than its true worth.
- Potential for high returns: Since value investors buy stocks at discounted prices, there is significant upside potential when the stock’s price rises to meet or exceed its intrinsic value. This can result in substantial gains over the long term.
- Focus on solid businesses: Value investors typically invest in well-established companies with strong fundamentals, making this strategy less speculative compared to other investment methods.
Disadvantages of value investing
- Time-consuming research: Value investing requires a thorough analysis of financial statements, business models and market trends. This in-depth research can be time-consuming and may require significant effort to identify undervalued stocks.
- Patience is essential: Unlike growth investing, which may yield faster returns, value investing often requires a long-term commitment. It can take years for the market to recognise a stock’s true value. Thus, investors must be willing to wait.
- Risk of value traps: Sometimes, stocks may appear undervalued but are actually in decline due to fundamental issues. These 'value traps' can result in poor investment returns if the company does not recover.
Value investing vs Growth investing
| Aspect | Value investing | Growth investing |
|---|---|---|
Investment philosophy | Value investors focus on finding undervalued stocks with strong fundamentals that are trading below their intrinsic value. | Growth investors seek companies with high growth potential, even if their stocks are trading at a premium. |
Risk level | It is less risky since investors buy stocks at a discount, providing a margin of safety. | It involves higher risk as it often targets companies in emerging industries with uncertain futures. |
Time horizon | It typically requires a longer time horizon, as it can take years for stocks to appreciate in value. | It may offer quicker returns, as growth stocks can rise rapidly if the company performs well. |
Conclusion
Value investing can be an excellent strategy for those who are patient, willing to conduct thorough research and interested in long-term gains. By focusing on undervalued stocks and applying a disciplined approach, value investors can build wealth over time while mitigating some of the risks associated with equity investments.
For those looking to diversify their investments, consider Axis Bank’s Mutual Fund offerings, which are designed to suit a variety of risk appetites and financial goals. With a range of funds catering to different investor profiles, Axis Bank provides a reliable option for those seeking professional management and steady returns in the market.
FAQs
What are some common mistakes to avoid in value investing?
Avoid value traps (undervalued companies with poor fundamentals) and overreacting to market volatility and ensure diversification across different industries.
How long should a value investor hold onto a stock?
Typically, you should hold a stock until the stock reaches or exceeds its intrinsic value, which could take several years.
Can value investing be applied to other asset classes besides stocks?
Yes, it can be applied to bonds, real estate and commodities by identifying assets below intrinsic value.
How do value investors deal with market volatility?
They focus on long-term fundamentals, staying disciplined and avoiding reactions to short-term price fluctuations.
Is value investing suitable for all types of investors?
It suits long-term investors with patience but may not be ideal for those seeking quick returns or those averse to short-term volatility.
Disclaimer: This article is for information purpose only. The views expressed in this article are personal and do not necessarily constitute the views of Axis Bank Ltd. and its employees. Axis Bank Ltd. and/or the author shall not be responsible for any direct / indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information. Please consult your financial advisor before making any financial decision.
Mutual Fund investments are subject to market risk, read all scheme related documents carefully. Axis Bank Ltd is acting as an AMFI registered MF Distributor (ARN code: ARN-0019). Purchase of Mutual Funds by Axis Bank’s customer is purely voluntary and not linked to availment of any other facility from the Bank. T&C apply.
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