Value Investing Explained: Principles, Strategies and Key Risks
Value investing is a strategy based on the idea that, sometimes, the markets misprice assets, and that investors can potentially profit by identifying companies trading for less than they are actually worth.
In simple terms, it involves buying stocks at a discount to their true value and holding them until the market corrects that gap. This guide covers how value investing works, the key metrics used to identify undervalued stocks and the risks involved.
The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.
Table of Contents
The Core Principles of Value Investing
Before looking at specific strategies or metrics, it helps to understand the principles that differentiate value investing from other investing strategies.
Three core principles of value investing are:
- Intrinsic Value: What a company is genuinely worth, independent of its market price
- Margin of Safety: Buying at a sufficient discount to protect against errors in judgement
- Patience: Allowing time for the market to recognise a stock's true value
Intrinsic Value
Intrinsic value is the estimated true worth of a company, based on its underlying fundamentals rather than its current share price.
Calculating intrinsic value is not an exact science. Investors typically use methods such as Discounted Cash Flow (DCF) analysis, which estimates the present value of a company's future cash flows, or earnings-based models that compare profitability against competitors.
Margin of Safety
The margin of safety is the gap between a stock's intrinsic value and the price at which an investor buys it. For example, if a company is estimated to be worth $50 per share but is trading at $35, the margin of safety would be 30%.
Its purpose is to protect against being wrong. Estimates of intrinsic value involve assumptions about future earnings and growth rates, both of which can prove inaccurate.
If the estimate turns out to be too optimistic, or the market takes longer than expected to correct, a sufficient margin of safety can potentially mitigate significant losses. Benjamin Graham, who popularised value investing, introduced the concept and treated it as a central discipline of the strategy.
Patience
Markets can remain inefficient for extended periods. A stock that appears undervalued may take months or years before other investors recognise that and push the price higher. Therefore, value investing can require patience as well as analytical skill.
Investors who exit positions too early, reacting to short-term price movements, often undermine the logic that made the investment attractive in the first place. Consequently, a long-term horizon is important to value investing, it’s what allows the strategy to potentially work.
How to Identify Undervalued Stocks
Identifying value stocks typically follows a two-stage process.
The first uses financial ratios and valuation metrics to identify stocks that look cheap compared to their fundamentals. The second stage involves a deeper look at the business itself in order to determine whether that cheapness is justified or whether it represents a genuine opportunity.
Key Financial Ratios
No single ratio tells the whole story but used together they help build a picture of whether a stock may be undervalued relative to its fundamentals. Some which are commonly used in value investing include:
However, none of these ratios on their own is confirmation of undervaluation. For example, a low price to earnings ratio may simply reflect a struggling business rather than a cheap one.
Consequently, investors might choose to use such metrics as a starting point for deeper analysis. Balance sheet health, particularly a company's debt levels relative to its earnings or assets, is also worth examining early in the process, as high leverage can undermine an otherwise attractive valuation.
The Business Behind the Numbers
As well as the metrics above, investors also consider factors that are harder to quantify but important to assess whether a business represents a potential value investing opportunity.
- Moat: Popularised by Warren Buffett, the term moat refers to a durable competitive advantage that protects a business’s market position. This could be brand strength, innovative technology or cost advantages that competitors may struggle to replicate.
- Management: Does the company have a good management team making the decisions?
- Industry Dynamics: What is the outlook for the industry? Is the company undervalued because its industry face long-term headwinds or has the market overreacted to short-term news?
A stock can look cheap on every financial metric and still be a poor investment if the underlying business is deteriorating. This is what distinguishes genuine undervaluation from a value trap.
Value Investing Strategies
Generally speaking, investors can approach value investing in two ways: actively, by researching and buying individual stocks themselves, or passively, by gaining exposure via a fund.
Active Value Investing
Active value investing involves researching individual companies and building a portfolio of stocks the investor believes are trading below their intrinsic value.
An example framework for this approach might include:
- Screening for stocks that appear cheap on one or more valuation metrics
- Analysing the underlying business to determine whether its low valuation is justified
- Estimating intrinsic value and identifying a sufficient margin of safety
- Holding the position until the market corrects itself or the investment thesis changes
Active value investing is time-intensive and requires a fairly high level of financial literacy, as well as a degree of patience and discipline. Consequently, this approach to value investing may not be suitable to everyone, particularly beginner investors.
Passive Value Investing with ETFs
For investors who want exposure to value stocks without conducting individual company research, value-focused ETFs (Exchange-Traded Funds) might be a more appealing option.
These funds track indices that screen for companies exhibiting value characteristics and rebalance periodically to maintain that exposure.
For example, the iShares Edge MSCI USA Value Factor UCITS ETF tracks an index composed of US stocks which exhibit value style characteristics. Specifically, the underlying index uses three variables to identify such stocks: Price-to-Book Value, Price-to-Forward Earnings and Enterprise Value-to-Cash Flow from Operations.
Funds like this allow investors to gain diversified exposure to value stocks without needing to research and pick individual stocks themselves.
However, the trade-off is that these ETFs track indices that are composed of stocks picked solely on financial metrics. No personal judgement is undertaken to establish whether stocks are genuinely undervalued or whether they actually deserve their low valuation.
Value Investing vs Growth Investing
Value investing focuses on stocks that appear undervalued relative to their current fundamentals; growth investing targets companies with strong future earnings potential, often at a premium valuation.
One practical difference that follows from this is valuation. Value investors actively target stocks with low valuations, a low P/E or P/B is part of what makes a stock attractive.
On the other hand, growth stocks tend to trade at higher valuations. That’s not because growth investors are seeking that, but because the market prices in future earnings potential, and when that potential is strong, it tends to be reflected in the price.
A growth investor would happily buy a high-quality growth company at a lower valuation; it's simply that the market rarely offers one.
Risks of Value Investing
No investment strategy is without its drawbacks, and value investing is no exception.
Value Traps
A value trap is a stock that appears cheap on valuation metrics but is cheap for good reason. This could be for a number of reasons, such as the business deteriorating or the industry being in structural decline. The danger is that an investor mistakes a permanently impaired business for a temporarily mispriced one.
Warning signs might include:
- Declining revenues over multiple periods
- A high dividend yield driven by a falling share price rather than a generous dividend
- High debt combined with weakening earnings
- Structural industry headwinds that show no sign of reversing
This is one reason the wider analysis discussed above matters. A stock can appear cheap on multiple metrics and still be a poor investment if the underlying business is in trouble.
Estimation Risk
Intrinsic value is an estimate, derived from a variety of assumptions which may all prove wrong. The margin of safety exists precisely because of this uncertainty, but even a generous buffer cannot fully protect against a fundamentally flawed valuation model or a business that unexpectedly deteriorates.
Consequently, value investors should be prepared to revisit their investment decisions if the evidence changes, rather than committing to holding a position.
How to Invest in Value Stocks
For those looking to put value investing into practice, a general framework might look as follows:
- Screening for Companies: Using valuation metrics such as P/E, P/B and P/FCF to identify stocks that appear cheap relative to their sector or historical range.
- Analysing the Business: For each candidate, look beyond the numbers. Is the cheapness justified by deteriorating fundamentals, or does the business appear fundamentally sound?
- Estimating Intrinsic Value: Form a view on what the business is actually worth. This doesn't necessarily need to be precise the goal is a reasonable range, not an exact figure.
- Assessing the Margin of Safety: Is there a sufficient buffer to protect against errors in your analysis?
- Monitor and Review: Review your holding periodically. Be prepared to act if the circumstances change.
Conclusion
Value investing is based on the idea that thorough analysis can help identify companies trading at prices below what they are genuinely worth. The core principles include establishing intrinsic value, applying a margin of safety and having the patience to hold a position whilst the market catches up.
However, value traps and estimation risk both present challenges. Furthermore, value investors need to be comfortable holding a position which may be out of favour for an extended period before the market corrects itself (if it ever does).
Other Articles You Might Be Interested In:
Frequently Asked Questions
What is value investing in simple terms?
Value investing is the practice of buying stocks that appear to be trading below what they are actually worth. The expectation is that the market will eventually recognise the stock's true value and correct its price accordingly.
Who invented value investing?
Value investing was formalised by economist and investor Benjamin Graham in the 1930s, most notably through his books Security Analysis and The Intelligent Investor. However, Graham's former student Warren Buffett, is probably its most notable proponent.
What is intrinsic value in investing?
Intrinsic value is the true value of an asset based on its underlying fundamentals, rather than its current market price.
What is a margin of safety in value investing?
The margin of safety is the difference between a stock's estimated intrinsic value and the price at which an investor buys it. It can act as a buffer against valuation errors; the larger the gap between price and estimated value, the more room there is for the analysis to be wrong.
What is a value trap?
A value trap is a stock that appears cheap on valuation metrics but is cheap for a fundamental reason, such as a deteriorating business or structural industry decline.
What is the difference between value investing and growth investing?
Value investing focuses on stocks that appear undervalued relative to their current fundamentals, whereas growth investing specifically targets companies with strong future earnings potential. The two approaches are not mutually exclusive, with many investors drawing on elements of both.
Who is value investing suited to?
Value investing tends to suit investors with a long-term time horizon and the patience to hold positions whilst waiting for the market to recognise a stock's true worth. A willingness to conduct extensive fundamental analysis is also important. It may be less appealing to those with a shorter time horizon or who are uncomfortable holding stocks that remain out of favour for extended periods.
INFORMATION ABOUT ANALYTICAL MATERIALS:
The given data provides additional information regarding all analysis, estimates, prognosis, forecasts, market reviews, weekly outlooks or other similar assessments or information (hereinafter “Analysis”) published on the websites of Admirals investment firms operating under the Admirals trademark (hereinafter “Admirals”) Before making any investment decisions please pay close attention to the following:
- This is a marketing communication. The content is published for informative purposes only and is in no way to be construed as investment advice or recommendation. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead of the dissemination of investment research.
- Any investment decision is made by each client alone whereas Admirals shall not be responsible for any loss or damage arising from any such decision, whether or not based on the content.
- With view to protecting the interests of our clients and the objectivity of the Analysis, Admirals has established relevant internal procedures for prevention and management of conflicts of interest.
- The Analysis is prepared by an analyst (hereinafter “Author”), with the assistance of AI tools. The Author Roberto Rivero is a contractor for Admirals. This content is a marketing communication and does not constitute independent financial research.
- Whilst every reasonable effort is taken to ensure that all sources of the content are reliable and that all information is presented, as much as possible, in an understandable, timely, precise and complete manner, Admirals does not guarantee the accuracy or completeness of any information contained within the Analysis.
- Any kind of past or modelled performance of financial instruments indicated within the content should not be construed as an express or implied promise, guarantee or implication by Admirals for any future performance. The value of the financial instrument may both increase and decrease and the preservation of the asset value is not guaranteed.
- Leveraged products (including contracts for difference) are speculative in nature and may result in losses or profit. Before you start trading, please ensure that you fully understand the risks involved.
