5 rules of value investing

Summary

  • Value investing means buying the stock at a discounted price.
  • Value investors find out the intrinsic value and margin of safety before investing.
  • Patience, knowledge, and conviction are value investors’ fundamental principles.

Value investing is the investment in stocks at a lower price than their intrinsic or book value. Thus, value investing is investing at a discounted rate. It is the same as buying items at a discount in a sale, where we know the item's actual value is more in the market. The same concept applies to value investing.

For example, investing in stocks, which are trading at a lower or discounted price than their actual price or intrinsic value, is value investing.

How to buy value stocks?

Here we discuss five rules to apply for finding value stocks in the market out of a trove of stocks.

Source: Pixabay

Also Read: How do you find hyper-growth blue-chip stocks?

Work out the intrinsic value

First, one should look for stocks that are trading at a discounted rate. 

To know the discounted rate, one needs to know the actual value first. Without knowing the actual value, the discounted rate is impossible to arrive at. It is, therefore, comparative and not absolute.

Moreover, with each external and internal change in the company’s dynamics, the actual /intrinsic value, and the discounted rate change.  

Discounted means the stock is undervalued. One must check the company's financials for its revenue, earnings, debt and cash positions, and industry performance to understand whether the stock is undervalued. Few popular ratios are generally used to find out the intrinsic value of the company. 

One of these ratios is the Price to Earnings ratio or P/E ratio. It shows the earnings per share to the company’s stock price. P/E ratio cannot be used alone to determine the value stock, but it is a vital measure to limit the search of a value stock.

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It shows the earnings power of the stock compared to the peers in the industry. For example, if industry P/E is 22% and the stock P/E ratio is 7%, this shows the stock has the scope to grow if other requirements are met.

The price to book value or P/B ratio is another metric to find the intrinsic value. Book value means the share value in the company’s book that is total assets minus total liabilities. If the book value is more than the market price of the share, it is a value stock on the P/B ratio parameter, and the investor should do further analysis.

Besides these, there are other parameters investors may compare and analyze like cash, debt, and revenue generation to find out value stocks.  

Also Read: Are these 10 global technology companies poised to grow in FY21?

Source: Pixabay

Also Read: Top ten growth stocks in the USA

Keep a higher margin of safety

The margin of safety is an essential concept in value investing. It is the difference between the undervalued market price and the intrinsic value or the stock's intrinsic worth.

When the margin of safety is higher, there are chances of a higher upside. It also reduces the chance to lose money suddenly and drastically if the stock and the sector go out of favor. 

The discount to the intrinsic value is the margin of safety. For example, if a stock's intrinsic value is US$100 but it is traded at US$70, which means it is trading at a discount. However, OwHHowever, However if an investor holds it until its price rises to US$100, the investor will earn US$30 in profit. On the other hand, if the stock is purchased for US$90, then the profit will be less. 

Analyze the stock and do not follow market sentiment

Value investing focuses on a stock’s intrinsic value and never goes with the trend. Value investors analyze the company’s financials, management, and overall expectations from the stock based on the available information to ensure the stock is available at a discounted price than the actual worth. 

Value investors typically follow the opposite direction from the herd. For instance, when the sell sentiments are high, they buy or hold the stock. In the case of buy sentiments, they sell the stock.

Thus, value investing demands patience and a conviction to stay invested in the stock when everybody else follow the emergent trend.


Also Read: Top blue-chip stocks to explore in the US market

Be observant of the company’s new developments

Value investment asks for patience, knowledge, and conviction to reap out the best benefits from investing. Once the stock is analyzed and finalized for investment at a particular rate, value investing requires a constant vigil though not daily.

Whenever the company is in the news, the value investors must keep a watch on its movement. It is not like investing in a mutual fund wherein, people invest and forget. But value investors refrain from daily buying and selling and do this only when necessary and for the long term. 

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Stay invested for the long term.

Value investing is done for the long term. Therefore, a value investor must have the mindset of the company's owner who invests money to grow manifold and not just earn a small profit and exit.

Finally, the practice of value investing has been in existence for a long time. The example of Warren Buffet stands out. He gave a new meaning to value investing. It was earlier tough to believe that an investor could earn huge profits through value investing.  

Please note: The above constitutes a preliminary view, and any interest in stocks/cryptocurrencies should be evaluated further from an investment point of view.


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