A majority of investors trade with the trend. A slight upward or downward movement of a stock may lead to hundreds of investors following the cue. This could lead to situation where the real value of a stock is higher than a stock’s current value. A fundamental analysis of the stock will show higher dividend yields but lower P/E ratio. This is where value investment comes to play. Let’s learn about the basics of this type of investment.
What is value?
While performing a fundamental analysis of a stock, you will notice that the price to earnings ratio is lower than average. The price to book ratio of the stock could also be lower than average. On the other hand, the stock could be giving a higher dividend yield. Delve deeper into the stock’s fundamentals and you will find that the stock is ‘undervalued’. This means that the real price of the stock is lower than its intrinsic value. For value investors, such undervalued stocks are like goldmines.
Note that every company with a lower than average P/E ratio qualifies as a value investment. The company’s historical data must suggest that it has strong fundamentals. The company’s management and current earnings record must all suggest that it is in a good place. The only undervaluation that the company has received is because of an irrational trend among the investors. Additionally, you must also be sure that as soon as the trend fades, the stock prices will come back to normal.
How to start value investing?
Once you have identified a value stock, you simply need to ensure that you have a ‘safe margin’. Let’s understand this with the help of an example.
The stock of company A is valued at Rs. 55.45. Due to an irrational trend among the investors, the stock prices have fallen to Rs. 55.40. In such a case, you have a very small profit margin.
If your calculation suggests that the intrinsic value of the share is Rs. 55.45 only, then a small fall of Rs. 0.05 will be quickly recovered. Hence, there will be no significant profit in buying this share as a value investor. You will have to buy these shares in bulk to call a small profit.
Now let’s understand the stock of company B. This FMCG Company has provided great returns to its investors historically. It has a strong management, good PR and is a leader in its industry too. However, the company comes under a storm due to a controversy related to its CEO.
Naturally, the prices of the company’s stock will fall. Once a fall is noticed, many investors will panic and start selling the stock due to negative publicity. The price of the stock immediately takes a fall from Rs. 55.45 to Rs. 55.25. So long as the controversy continues, the prices will fall.
However, a value investor knows that the company has very strong fundamentals. The prices are falling because the investors have hit the panic button. Otherwise, the company looks strong both fundamentally and financially. Hence, the value investor will buy stocks of this company at Rs. 55.25. Let’s assume that he buys 10,000 shares of this undervalued stock for Rs. 5, 52,500.
When the controversy dies down or the problematic CEO is ousted by the board, investor confidence will be back and the stock prices will rise. This time the value investor sells for the original value Rs. 55.45 per share or even higher to earn a profit. If he sells at original value, he will earn Rs. 5, 54,500.
Value investing is based on two fundamental ideas:
1- Investors may not always behave rationally while buying or selling a stock.
2- The current stock price of a company may not be the best indicator of a company’s value.
Note that value investors do not buy smaller number of shares. They must buy in larger quantities to make a significant profit. Additionally, value investing is tricky. Two investors may not always believe that a stock is undervalued. Hence, you must be cautious.