Value investing in the Stock Market: The principle of value of investing is to buy stocks at less than their intrinsic value. Benjamin Graham is recognised as the original proponent of value investing. Graham’s book, ‘The Intelligent Investor’ written in 1949 is considered a classic. Legendary investor, Warren Buffet described it as “by far the best book on investing ever written.”
Share values on the stock exchange can be volatile, driven by emotion and new events. For many investors trying to accurately time every upward or downward movement of a stock is pointless speculation. The value investment approach attempts to insulate an investor from the vicissitudes of the market.
Determining the intrinsic value of a stock, however, is not an easy task. Analysts will conduct fundamental analysis to try and identify stocks they believe are undervalued. Value stocks are often found in industry sectors that are going through a bad period. Regardless of what the market is doing, their approach is that the long term fundamentals of the company are paramount.
Value seekers often look at the company’s price to book ratio, price to earnings ratios or dividend yields before investing in the stock market.
Price to book ratio is a comparison of a company’s share price to its book value. The book value is the total amount that would be left if the company sold all its assets and repaid all its liabilities. To calculate the book value per share, divide this amount by the number of shares outstanding. For example, if the book value of the company was $10,000,000 and there were 1,000,000 shares the book value per share is $10. However, the share may be trading at $15 on the market. The result is a price to book ratio of 1.5.
A P/B ratio of less than 1.0 indicates the stock may be undervalued. A ratio of greater than 1.0 indicates a stock could be overvalued. Of course a company may have a high P/B ratio just because it is a bad company and the low share price reflects that sentiment.
Price Earnings (P/E) Ratio is
the ratio of the share price of a stock and the earnings per share. It is a popular ratio used in investing in the stock market.
If the EPS of a company is $2 and the stock price is $50 then the P/E = 25. It is not particularly relevant as a figure on its own. Analysts typically compare the P/E of a company with other companies in the same sector or against the company’s own historical P/E. Some use it to calculate the future earnings of a company. Investors interpret a high P/E ratio as meaning future growth. P/E tends to average around 20 to 25 times earnings. It can also show how much investors are willing to pay per dollar of earnings. In the previous example, investors are willing to pay $25 for every dollar of earnings.
Dividend Yield measures what an investor earns in the form of dividends.
A company that continues to pay dividends even through challenging market conditions is often seen as a good sign. It means they are confident of its future cash flows. Even if the share price has declined, the fact that it is paying dividends means the investor will still see some return as they wait for the share price to recover. Note that dividends are paid at the discretion of the management and can be stopped at any time.
Analysts will also compare results with competitor companies operating in the same sector before investing in the stock market. Ultimately, however, the decision as to whether the share price is below intrinsic value is a subjective one. Graham acknowledged that an investor may calculate the intrinsic value incorrectly. To account for this he advocated the idea of a “margin of safety”. The further below the stock price is below its intrinsic value, the greater the margin of safety. For example, an investor may calculate a stocks intrinsic value to be $50. The stock may be trading at $47.50 and so appears good value. However, the investor’s policy is to allow for a 10% margin of safety before buying. This approach means they could only buy the stock when it declines 10% from intrinsic value to $45.
Another way to spread risk is to diversify by investing in a portfolio of shares.
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