Value Investing Definition How It Works Strategies Risks
Value investing is an investment strategy that involves picking stocks trading below their intrinsic or book value. Value investors actively seek stocks that the market is underestimating, believing that the market often overreacts to news, leading to stock price movements that don’t align with a company’s long-term fundamentals. This creates an opportunity to purchase stocks at discounted prices.
The basic concept of value investing is straightforward. If you know the true value of something, you can save money when you buy it. In the stock market, a company’s share price can change even when its valuation remains the same. Strictly speaking, there is no true or intrinsic value of a stock. However, there are relative values.
Market participants can buy or sell shares without being tethered to an objective price. Therefore, stocks go through periods of higher and lower demand, causing price fluctuations. If a company’s fundamentals and future opportunities remain unchanged, then the value of its shares is largely the same even though the price may differ.
Value investing developed from a concept by Columbia Business School professors Benjamin Graham and David Dodd in 1934. It was popularized in Graham’s 1949 book, "The Intelligent Investor."
Value investors believe that the markets aren’t efficient and that stocks may be over or underpriced for various reasons. They don’t follow the herd and often buy when others are selling and vice versa. Value investors focus on a stock’s intrinsic value and prefer to invest in companies with sound principles and financials.
Estimating the true intrinsic value of a stock involves financial analysis and some subjectivity. It requires diligence and patience to stick with an investment philosophy. Value investing strategies include raising prices, increasing sales figures, decreasing expenses, and selling off unprofitable divisions.
Value investing does come with risks, such as relying on accurate financial analysis and the potential for buying overvalued stocks. It’s important to diversify and avoid making emotional investment decisions.
A real-life example of a value investment is Fitbit. After its Q1 2016 earnings report, the stock price declined significantly despite meeting analyst expectations and increasing guidance for the year. A value investor who understood the company’s fundamentals and saw it as undervalued would have made a profitable investment. In 2021, Google purchased Fitbit for $2.1 billion.
Overall, value investing is a strategy that aims to capitalize on market inefficiencies by identifying undervalued stocks and holding them for the long term.
Value investing is an investment philosophy that involves purchasing assets at a discount to their intrinsic value, also known as a security’s margin of safety. Benjamin Graham, the father of value investing, established this term with his book, "The Intelligent Investor," in 1949. Notable proponents of value investing include Warren Buffett, Seth Klarman, Mohnish Pabrai, and Joel Greenblatt.
Common sense and fundamental analysis underlie the principles of value investing. The margin of safety, the discount a stock trades at compared to its intrinsic value, is one leading principle. Fundamental metrics such as the price-to-earnings (PE) ratio illustrate company earnings in relation to their price. A value investor may invest in a company with a low PE ratio as one barometer for determining its value.
Along with analyzing a company’s price-to-earnings ratio, common metrics include the price-to-book ratio, free cash flow (FCF), and debt-to-equity ratio (D/E).
First coined by Benjamin Graham, "Mr. Market" represents a hypothetical investor prone to sharp mood swings of fear, apathy, and euphoria. "Mr. Market" symbolizes the consequences of emotionally reacting to the stock market rather than rationally or with fundamental analysis. As an archetype for behavior, "Mr. Market" speaks to the price fluctuations inherent in markets and the emotions that can influence these on extreme scales, such as greed and fear.
Value investing is a long-term strategy. Warren Buffett, for example, buys stocks with the intention of holding them almost indefinitely. He once said, “I buy on the assumption that they could close the market the next day and not reopen it for five years.”
You will probably want to sell your stocks when it comes time to make a major purchase or retire, but by holding a variety of stocks and maintaining a long-term outlook, you can sell your stocks only when their price exceeds their fair market value (and the price you paid for them).
