You might have already heard of value stocks if you spend a bit of time with active investing in general. A value stock is exactly what its name implies, -a stock that is supposed to be especially characterized by its value. But what exactly does value mean when it comes to investing and what differentiates value stocks from other types of stocks?
What Is a Value Stock?
A value stock is essentially described as a stock that is trading at a discount of its intrinsic value – in other words, a stock that is priced below its true worth. The true value of a stock is often defined by commonly used fundamental factors such as a low price-to-earnings ratio (P/E), low price-to-book ratio (P/B) and a high dividend yield. Value investors assume that every stock has a true value that can differ from its current market price. The real value of a stock can’t be actually seen and has to be determined by the individual investor.
For instance, when the investor estimates that the intrinsic value of company ABC is $80, while the stock is currently priced at $120, the conclusion would be that the stock is priced at a discount of what it is really worth. Therefore, investing in company ABC may be considered a valuable investment.
Besides the intrinsic value, common characteristics that value stocks have are financial metrics that express increased financial value in relation to the stock’s price. The most commonly used metric is probably the P/E ratio, which shows the relation between the earnings per share (EPS) and the current stock price. Moreover, a low price-to-earnings ratio indicates that investors are getting more earnings for a lower price when investing in that company, compared to a stock that may have a higher P/E ratio.
How to Find Value Stocks
One of the easiest ways to find stocks that hold good value according to financial metrics, which were mentioned above is by using a stock screener. Stock screeners are tools that investors can use to filter stocks based on the preferred metrics chosen by the user. Examples for filters that you might want to apply for value stocks would be companies that are under a specific P/E ratio, P/B ratio, a certain dividend yield and constant EPS growth over the past years.
Additionally, it may be beneficial to compare the financial metrics of a stock with other companies that are operating within the same industry. For instance, you could find out the average P/E ratio of major airlines and thus assess if the analyzing stock is trading below the average P/E or not. Note that it would only make sense to compare the financial metrics of companies within the same industry, as in general, different industries will usually have completely different P/E levels.
For example, as of January 2020, Telecommunications Services have an average price-to-earnings multiple of 17 while the Technology sector holds an average P/E of about 45.
That being said, even if all required financial metrics would indicate that a stock is cheap, it may not be enough to find out if a stock is worth the investment until you determine the intrinsic value of it. While estimating the true value of a business is probably going to be the more advanced part of stock analysis, it is still very necessary for some value investors. The most common way to find the intrinsic value is the Discounted Cash Flow Analysis (DCF). Only once a stock is priced below its intrinsic value, you may want to consider it a good value stock.
Oftentimes, stocks fall into a valuable price level when the underlying company gets hit by negatively related events and activities. Stock prices are a reflection of how investors view a company, which concludes that fundamentally sound companies can suddenly become undervalued when something bad happens within the company. In this case, it is up to the investor to evaluate if the affected company is only temporarily faced with negativity, or something fundamentally has changed to the worse.
Are Value Stocks Better Than Other Stocks?
When it comes to active investing, people often distinguish between two main investing styles: value investing and growth investing. While it may seem logical that undervalued stocks in terms of low P/E and low P/B will certainly perform better than other stocks, in reality, this isn’t always the case. For instance, growth stocks have clearly beaten value stocks in the past decade. However, value has historically beaten growth in the very long term.
That being said, it is hard to determine if value stocks are necessarily better than other stocks, as there will be periods of time where value underperforms or overperforms the rest of stocks. What’s more important is that the market will have to realize the undervalued position of a value stock for the investor to actually make a profitable return. Sometimes that might not happen as quickly as the investor can remain patient or liquid.
Examples of Value Stocks
If we consider stocks with low P/E ratios being value stocks, then as of January 2020, many companies operating within the financial sector could be viewed as cheap such as Bank of America (BAC) with a P/E of 13, JPMorgan Chase (JPM) P/E = 14, or Morgan Stanley (MS) with a P/E of 11, which all have a significantly lower price multiple than the S&P 500, with an overall P/E of 24.
Additionally, investors have the option to invest in Value ETFs that track a grouping of many value stocks as a whole. Some of the most established Value ETFs include the Vanguard Value ETF (VTV) and the iShares Russell 1000 Value ETF (IWD).
Stocks that are priced cheaply relative to their value according to most financial metrics are considered by investors as value stocks. While low fundamental ratios such as the price-to-earnings ratio or the price-to-book ratio may be necessary for some value investors, only evaluating good investments based on their fundamental metrics might just not be enough in today’s time. Experienced value investors will most likely perform deeper valuation analysis to determine the true value of a stock and then evaluate from a more advanced point of view if a stock is worth the investment or not.