Just like coming across captivating deals on discounted products at the supermarket, investors may also often get the opportunity to go after bargains on the stock market. Many famous value investors such as Warren Buffett have achieved incredible investing success by applying the principle of looking for bargain stocks. Here are several points you need to understand in the first place in order to start buying stocks at a discount of their value.
The Inefficiency of the Market
As soon as you spend some time learning about investing in the stock market, you may quickly realize that stock prices can constantly fluctuate as quickly, as the investor’s view about the underlying business can change. This only makes sense since a great number of a company’s shares usually switch owners countless amount of times throughout the day. When something bad happens, and investors start losing their confidence in a company, it is very likely that its stock price will suffer as a result of lower demand.
In some cases, the sentiment of investors might go too far in both directions. For instance, people may over exaggerate a negative event occurring within a business to the point, where its stock price might fall 30% or 40% within a short period of time, even if the financial health of the underlying company may not be as bad as reflected by the sudden price fall. On the other hand, investors might also become overly optimistic about the future growth of a company, which then can lead to a constant price increase that encourages more people to invest, inevitably resulting in a price bubble.
In other words, the irrational behavior of human thinking can oftentimes lead to the result that current stock prices, which are determined by the investors don’t necessarily reflect the true value of a business. Therefore, there is a clear difference between price and value and those two will frequently deviate from each other. This principle is also called market inefficiency and many investors, especially value investors do believe that markets are more or less inefficient.
Understanding Price and Value
“Price is What You Pay; Value is What You Get”
In order to find and buy stocks at a discount of what they’re really worth, you need to clearly understand that the price of a stock doesn’t always reflect its true value.
When you purchase a stock, you pay a certain market price, which can be heavily determined by subjective factors. These factors can sometimes cause the stock price to fluctuate heavily. On the other hand, value is what really lies within the asset and what you actually should be looking for. The value is mainly dependent on the future cash flows that the investment can provide and doesn’t fluctuate as excessively as the price.
Investors are essentially seeking investments that can return a greater amount of cash flow in the future than what they initially paid. The price which you pay plays a very important role in the return that you are going to get. The higher the price, the lower your return since the margin between the purchase price and selling price (and dividends) will decrease accordingly.
How to Assess the Value of a Stock
One method being commonly used is to apply financial metrics to analyze and get a better view of the value of a stock. Some of the most commonly used financial metrics that can give you useful insights about the stock’s worth include:
The Price-to-earnings-ratio (P/E ratio)
The P/E of a stock compares the earnings per share and the current market price and is used to determine how much earnings power you as an investor are getting for the price that you have to pay in order to acquire one share. A high P/E ratio could indicate that a business is overvalued relative to the earnings because investors are willing to pay a high multiple of earnings that the company produces, while a low price multiple may indicate that a stock is undervalued as you are essentially paying fewer dollars for the earnings of a business.
To further understand what the P/E ratio essentially depicts, you could imagine that the P/E figure shows how much investors are currently willing to pay based on the past earnings of the business. For instance, if a company was currently trading at a P/E of 25, investors would be willing to pay 25 times the earnings or $25 in order to get $1 of earnings.
Using the P/E ratio in practice isn’t as easy as described in theory. Just because a company has a price multiple of 10, it doesn’t necessarily mean that it’s a better investment than another company that has a price multiple of 20.
Two primary ways to use the P/E ratio (that make more sense) would be to either exclusively compare the price multiples of companies that are operating within the same industry because the average P/E ratio will heavily vary from one industry to another, or to compare the current price multiple of a stock with its own historical record to assess how the value of the business has changed over time.
The Price-to-book-ratio (P/B ratio)
Similarly to the P/E ratio, you can use the price-to-book ratio to compare the market price with the book value of the stock instead of its earnings. Just like the earnings multiple, the P/B ratio can also indicate if a company is undervalued. There are a few cases when looking at the book value could be extremely beneficial to assess a value investment. When comparing two companies that are similar to each other in terms of growth, earnings and debt levels, the P/B ratio might be the crucial indicator that could make one investment the better choice than the other.
Since the equity of a business doesn’t fluctuate too much as opposed to the P/E ratio, using the P/B ratio can oftentimes turn out to be handier in some circumstances. For instance, a price-to-book ratio of under 1 could indicate that a business is currently trading for less than what it’s actually worth, potentially making it a strong value pick.
Calculating The Intrinsic Value
This method is mostly used by value investors and involves the act of trying to calculate an actual number which is the intrinsic value (also called fair value) of a business.
“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”
Just like the quote by Warren Buffett above states, it is easy to define the intrinsic value. However, it’s definitely a more complicated act to come up with an intrinsic value than to describe it.
The intrinsic value is basically the future amounts of cash that the investor can get from a business, which is discounted back into the present. The discounting is necessary because of the relatively simple concept of the time value of money (TVM).
Basically, you need to first estimate how much cash a business will likely be able to produce in the future and then discount the sum of the future cash flows with a discount rate, which will depend on the return that you want to get from the investment. In other words, the higher the return that you want to get from an investment in the future, the lower the cost would need to be to acquire the investment in the present.
In practice, there is no ‘right intrinsic value’, as the valuation process will be different for everybody based on different growth assumptions, required rates of return, etc. Calculating the intrinsic value is just an attempt to determine an actual number, which you as an investor would be willing to pay for a stock. If the intrinsic value is lower than the current market price, then the stock can be considered undervalued.
As an investor, buying stocks at a discount requires you to understand that market prices don’t always reflect the true value of a business in the first place. A small-cap stock could jump up to the roof and become overpriced as a result of heavily inflated expectations, while a financially stable business may fall in price due to temporary pessimism and negative events. In order to take advantage of discounted stocks, you would need to find businesses that temporarily fall into a bad light or other negative circumstances. One of the common ways to find discounted stocks is to apply financial metrics, which will give you better insights about their current value. That being said, finding discounted stocks is not an easy thing to do and requires a certain amount of patience and willingness of constant learning.