Value investing involves choosing stocks based on the belief that sometimes the market doesn’t reflect the true (“intrinsic”) value of a company and trades its shares at a discount. Value investors believe the market will eventually realize the company’s true value and the stock price will adjust upward accordingly.
The key to value investing is being able to determine the difference between a company that is undervalued and a company whose value is low for good reason.
VALUE VS. GROWTH
It’s helpful to understand value investing by comparing it to growth investing. Growth investors seek to capitalize on upward trends in the market. These investors pay no attention to stock price as it relates to a company’s intrinsic value; they look for companies that have been exhibiting rapid earnings growth and are expected to continue to do so. Conversely, value investors seek out companies that may not currently be not doing well or are in industries that are out of favor, but that are expected to do better in the future. Both growth investors and value investors seek stocks with good growth potential, but growth investors focus on companies that are currently experiencing growth, while value investors focus on companies that may currently be experiencing little or no growth or whose stock prices they believe will increase in the future to more closely reflect the company’s prospects.
A value-oriented investor is often more focused on a company’s fundamentals–its price-earnings (P/E) ratio, earnings per share, and so on–than a growth investor, who might give more weight to increases in a stock’s sales per share or earnings per share than to its P/E ratio, which may be irrelevant for a company that has yet to produce any meaningful profits.
The main risk of value investing is that the expected turnaround never happens or takes longer than expected. The main risk of growth investing is paying a premium in anticipation of expected earnings that don’t meet expectations.
Growth investing is often seen as the opposite of value investing, but they can also be seen as complementary strategies. Stocks can be categorized as either growth or value, and market cycles typically favor one over the other. Thus, having both types of stock in a portfolio can help an investor diversify.
DISTINGUISHING BETWEEN A VALUE COMPANY AND A GROWTH COMPANY
Growth companies tend to be those that offer products or services that are currently very popular or are perceived to have great promise. These can be companies in emerging industries or established companies with accelerating earnings.
Value companies are out of favor with investors for the moment. They could be new, emerging companies that are not yet recognized by the market, but more typically they are mature companies that are overcoming internal problems such as legal or management difficulties or whose business is cyclical in nature.
Growth companies and value companies can be distinguished by their particular traits. Below is a table that compares and illustrates some common characteristics of each.
DISTINGUISHING BETWEEN A VALUE COMPANY AND A LOSER
The value investor’s job is to distinguish between companies that have the potential to overcome their difficulties and languishing companies that are unlikely to recover.
How can an investor tell if it’s a value stock and not just a loser? He or she must look carefully at the company; its financial reports, its management team, its products and services, and its operations. Here are some measures typically looked for by value investors:
- High private market value (also known as transaction or acquisition value)
- High liquidation value
- Sound financial condition
- Identifiable turnaround situation
- Intangibles (e.g., strong brand-name recognition, change in ownership or management, company is a monopoly or near-monopoly)
- Assets that are being ignored by investors
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