[Two common philosophies of stock investing are "value investing" and "growth investing" - growth investing is covered in another post]
Most investors consider value investing to mean buying cheap or discounted stocks, but there is more to this investing strategy.
Value investing deals with the buying of stocks that have been neglected by the market and their price is lower than their real value. The problem of course is how do you know what the true value of a stock is? Value investors typically pay extra attention to the fundamentals of the business in order to try to figure out if a stock is being under-valued by the markets.
How value investing is done
The business fundamentals that value investors usually consider are the earnings growth, cash flow, dividends and book value. Most value investors invest for the long term and they tend to buy and hold stocks for long time periods – sometimes forever. A common strategy of value investors such as Warren Buffett is to buy companies they like when the stock price has gone down. The assumption is that if a company is a reasonable deal at one price, then it must be “on sale” if the price drops.
One of the risks of value investing is that the stock price might be heading downward because of problems at the company or in the industry. If the problems are temporary and the stock jumps back up over time then the value investor will do well. On the other hand if the investor has bought into a “value trap” then they will not be happy since the stock will keep going down.
Why do I need to know this?
A lot of mutual funds are slanted towards one investing style or the other. You can usually (but not always) tell by the name of the fund – it might have the word “value” or “growth” in the name. If you research the fund you should be able to figure out if it is one or the other or some combination of the two.
Value Investment Criteria
A value investor might look at some of the following to determine if a stock is a good value.
- The Price to Earnings (P/E) Ratio – This ratio varies from industry to industry but a value stock will have a p/e ratio that is low compared to other companies.
- The Debt to Equity Ratio – Debt can be a good tool when used properly but too much of a good thing can be bad. This ratio also varies between industries.
This post was featured on the Personal Finance News Carnival Vol. 8.