Value Investing Basics

Most investors regard value investing as purchasing cheap or discounted stocks. However, this investing strategy is more than this.

Value investing refers to the purchase of stocks that have been overlooked by the market and as a result their price is below their real value. This means that the real value of a stock is not correctly reflected by the price at which it is traded.

If you are a value investor you should pay special attention to the business fundamentals. The latter should be on the top of your list of criteria and priorities. Only after this should the other influences be considered.

Business fundamentals that you should study include:

• Earnings growth
• Cash flow
• Dividends
• Book value

These should be of higher importance than the rest of the market conditions that may influence the price of the stock you have selected.

Value investors have a long-term focus. They buy and hold stocks for long periods of time, waiting for the market to correct the price of the stock to match its real value.

Therefore, when considering a particular company the first thing that a value investor does is the examination of the business's fundamentals. If there is nothing wrong which can be attributed to the low price, then the stock is a perfect option for an investment. After the market corrects the price, the value investor is rewarded for his/her patience.

A decrease in the price of a stock may be an indication for a value investment candidate. However, sometimes the market is right when decreasing the price due to problems with the fundamentals of the business. Some of the reasons for the decline may be a fall in the earnings or revenues. Additionally, the industry may have experienced a change, which has affected the product line of the company.

Value Investment Selection

In order to determine whether a stock is qualified as a value one, you should look for these basic criteria:

1. The Price to Earnings (P/E) Ratio

   It should fall in the 10% of the lowest that is typical for the sector in which the company falls.

2. The Debt to Equity Ratio

   It should not be greater than 1.

3. The PEG

   It should not be greater than 1. This shows that the stock has been overlooked by the market and as a result its value is below its real one.

4. Earnings Growth

   A record of consistent Earnings Growth should be provided over a long period of time. You should look for an earnings growth from 6% to 8% for a 7 to 10-year time period.

5. Stock Price

   The price you pay for the stock should not exceed 70% of the intrinsic per share price of the stock.

6. The Price to Book ratio

   It should not be greater than 1.

Intrinsic Value Defined

Most of the current accounting standards fail to accurately reflect the value of intellectual property assets. As a result they are rarely reflected in the financial statements of companies.

Market value reflects tangible assets, whereas intrinsic value reflects intangible assets, such as trademarks, patents, brand, R&D (research and development) and many others. These intangible assets represent the driving force that pushes the future growth of the business.

The calculations surrounding intrinsic value are complicated. However, you can refer to the many sources that execute the estimations for you. Some of them are MorningStar.com or Reuters.com.

No matter which way you select to calculate the intrinsic value of a stock always leave some room for error. You can also check whether the source has made the required room for error.

Value investing requires you to practice the necessary patience and hold the stock over the long-term. With time your patience will be well rewarded.

For a trading platform we recommend you try Zecco and E*TRADE.
Zecco offers free stock trades, no account minimum, real time quotes, trading community, and is also insured and protected against loss by SIPC. Opening a Zecco account to benefit from $0 Stock/ETF trading is a smart idea. Free stock trades allow you to preserve more of your wealth and save money, which you can invest instead of paying brokerage commissions.
E*TRADE is ranked #1 Online Broker for third straight year by SmartMoney magazine (written by the Wall Street Journal editors and owned by Dow Jones). The ranking was based on the following categories: mutual funds & investment products, banking services, research, trading tools, and customer service. They have been in this business for 25 years, have 4.5 million accounts worldwide and $100 Billion in customer assets. Open an E*TRADE account here and get 100 commission free trades.

For knowledge we can highly recommend you subscribe to the The Wall Street Journal.

Bookmark this page (CTRL+D) :