To be a successful trader, you have to identify opportunities that wouldn’t be normally available. In the world of trading stocks, value stocks are highly sought-after. To explain what is a value stock, we have to explain the unique characteristics of these stocks.
But even before that, we can touch on the other types of stocks that exist, explain them, and hopefully give you a better idea of how value stocks differ. From all the types of stocks that exist, growth stocks are mostly contrasted with value stocks. A growth stock, in short, is a company that is expected to grow much faster than the market average.
You’ll notice that growth and value stocks are entirely different types. The difference can help you identify which stock is characterized as a value stock in practice. So with all that out of the way, let’s explain what is a value stock.
Understanding What Is A Value Stock
A value stock is simply a stock that has a much lower price than what the company actually performs on the market. In even simpler terms, a value stock is one that underperforms in terms of price, but the company itself overperforms. When these two metrics don’t align, investors look at value stocks as potential investments for their portfolios. Since investors know the importance of diversifying their investment portfolios, both value stocks and growth stocks are important to look at.
A typical investor’s portfolio will include both, and even a few other types of stocks as well. While growth stocks have incredible growth potential, value stocks hope to bring profits in the long term. Warren Buffett is a high-profile proponent of value investing.
Characteristics Of Value Stocks
Whenever looking to invest in stocks, there are two ways to approach it. You can either pick a stock that you like, or you can do your research. The latter is the approach every smart investor takes. With research and analysis, investors are able to identify value stocks and diversify their portfolios to include as many different securities as possible. By doing this, investors minimize risk and maximize portfolio growth opportunities.
So if you want to invest in value stocks, you have to first spot them. To spot and identify value stocks on the market, you have to look at the unique characteristics of these types of stocks. These unique characteristics are almost always negative in the grand scheme of things. Investors look at companies that are going through rough events, where their stock price fares much lower compared to other companies from the same industry.
Maybe the particular company is going through a particular event that negatively reflects on the stock price. A prime example is legal problems. If a company is getting sued, then there is a very real chance the stock price will go down due to negative publicity. Investors look for these companies when value trading. But it’s important to mention that the company will almost always be in a healthy financial situation. The reason that the company’s stock is considered a value stock is due to recent events.
How Are Stocks Valued?
The characteristics of value stocks are closely tied to the actual valuation investors give these stocks. As mentioned previously, research is an investor’s bread and butter. That means investors will always do their research and identify value stocks based on four basic elements of stock value.
One of the most influential elements is the Price-To-Book ratio or P/B ratio. A P/B Ratio takes into account everything that the company owns. This includes physical elements like assets, buildings, and land, but also includes the company’s stocks and bonds. The P/B ratio represents how much investors are going to get if the company is sold at that very moment.
Depending on the type of company, the physical or portfolio (stocks and bonds) assets will differ. Some companies own more physical assets, while others have a much larger portfolio.
Another ratio to look at is the Price-To-Earnings Ratio or P/E ratio. This element only works when comparing a company with other companies in the same or similar industry. When looking at the P/E ratio, it’s important to mention that it tells investors about how long it will take for investors to get their investment back. A P/E ratio of 5 means that it will take five years for the investors to get their money back.
Other elements used to value stocks include Price-To-Earnings Growth Ratio and Dividend Yield.
Potential Risks With Value Stocks
Investing in value stocks isn’t without risk. While it’s easy to find stock picks this week and identify the value stocks, the hard part is not taking into account the potential risks of doing so. Warren Buffett might be one of the most influential value investors, but that doesn’t mean he blindly invests in the first value stock he comes across.
No doubt the biggest risk of value investing is falling into a trap. While this might sound like chicle, it is real nonetheless. Investors might identify a cheap stock, but the trap of investing is overlooking the fact that the company isn’t performing well. Maybe profits are constantly down, the sector is performing poorly, earnings are volatile, or simply the company is poorly managed.
These are all factors that cannot be overlooked. Even if the company’s stock price is cheap, the company shows no signs of overcoming these issues. This is a prime example of falling into a value trap.
But unless another stock market crash occurs, value stocks are generally safe if you do your due diligence.
Long-Term Over Short Term
While the risks of value trading do exist, a good investor knows that value stocks are tickets for the future. What we mean by this is that value stocks are more long-term orientated. Since the company in question is experiencing negative events that reflect poorly on the price, investors hope that the company recovers in the future. And we’re not talking about weeks or months; investors generally hold value stocks for several years.
The underlying risk or value stocks make them more desirable as long-term investments. Growth stocks, on the other hand, are short-term investments.
Growth Vs Value Investing
This topic always comes up whenever growth or value investing is the subject of discussion. These two types of investing are quite possibly the most different from one another. While we’ve talked so much about value stocks and growth stocks, these two types of investing have vastly different characteristics. Let’s elaborate more on that.
- Value Investing Characteristics
|Low Price-To-Earnings Ratio||Low Price-To-Cash-Flow Ratio||Slow Earning Growth (Long-Term)||High Dividend Yield|
- Growth Value Characteristics
|High Price-To-Earnings Ratio||High Price-To-Cash-Flow Ratio||High Earning Growth (Short-Term)||No Dividend Yield|
How To Invest In Value Stocks?
To figure out how to invest in value stocks, we have to look at what investors hope to achieve when buying value stocks. In short, investors are looking at stocks that are trading at a discount. This is essentially the main goal of value investing. The thinking is that the price of the stock will eventually correct and investors will make a big return. As we’ve mentioned numerous times, value investing is more long-term orientated.
Investors are actively looking at companies where the stock price doesn’t accurately represent the true value of the company. Through time, investors believe that these companies will realize their true market value, and that will, in turn, launch the stock price up.
There is an old cliche that goes like this: “Value investors are looking at buying a $100 bill for $80.” Investors look at value stocks like bargains that are quickly moving. So the window to jump through is very small. While thousands of investors are looking at these stocks at the same time, the window to invest is very small. Since everyone wants to buy a $100 bill to $80, investors don’t have a lot of time before everyone eventually jumps on that one particular stock.
For the most part, value stocks are underappreciated stocks where the value doesn’t reflect the company’s potential. Due to many factors, the company is going through a rough patch that makes it less desirable, hence why the value is so low. Value stocks are almost always cheap stocks and investors are looking at long-term potential over short-term. While short-term success can be achieved, it rarely happens.
To successfully identify value stocks, you need to look at factors like P/E Ratio, P/B Ratio, growth earnings, and dividend yield.
Partner at Vega Capital Management - a private funds management company.
An experienced portfolio manager with 10+ years of proven and reputable track record in investment management and financial analysis. Currently, a partner at one of the fastest-growing private fund management companies in southeast Europe, Kiril has been tending to a loyal international base of client-investors and partners. When he is not crunching numbers and increasing his client’s wealth, he reminisces about his Michelin-star restaurant cheffing years and fondness of the culinary arts.