What is Value Investing?

Instructor: Michelle Reichartz

Michelle has lead multiple training initiatives and has a master's degree in Business Administration.

In this lesson, you will learn what the value investing strategy is, how it is calculated, an alternate method of value investing, and factors to consider when utilizing this strategy.

Your Next Car

Buying a new car can be a tedious process. Between doing your research, test driving a few vehicles, and negotiating the price, finding the right fit can be a long process. When you think about it, what is the overall goal of this research and careful consideration?

Most people can agree that they want great value at a good price when making major purchases, such as a car. They want to believe they got far more value than what they actually paid.

This premise is what the investing strategy known as value investing is modeled after.

What is Value Investing?

Value investing is a popular strategy that has been used for years on the stock market. One of the most successful users of this strategy is Warren Buffett, the CEO of Berkshire Hathaway. In fact, you probably use this strategy every week without realizing it at the grocery store! Why pay full price for a product when you can get the same value for a smaller price?

Value investing attempts to gain value by buying stock in a company that is undervalued. Undervalued is when a stock is selling for less than its true worth.

How to Calculate a Stock's True Value

The biggest question you may be asking yourself is likely this: how do I calculate the true value for a stock? It's an important question, and the answer is found by looking at the operations of the company behind the stock. Many websites that provide the stock information of a company also offer the ratios needed to determine if that stock is a good choice for the value investing strategy.

Here are a few ratios commonly used to determine if a company's stock is undervalued:

  • P/E Ratio: Also known as the price-earning ratio. This number tells you how much the price of the stock is in comparison to the earnings per share. For example, if a stock is priced at $100 and the earnings per share is $10, the P/E ratio would be 10. A value investor would prefer this number to be low, as it indicates the current price of the stock is low in comparison to the earnings the company is making.
  • Current Ratio: This ratio compares a company's total assets against their total liabilities. For example, if a company has $50,000 in total assets with $10,000 in total liabilities, the current ratio would be 5. Value investors like this number to be high since it indicates that the company could quickly pay off its current debts, if needed.
  • Profit Margin: Profit margin is the net profit divided by total sales to show the final value as a percentage. For example, if a company's net profit is $7,000 and its total sales are $21,000, the profit margin would be 33.3%. A value investor prefers this number to be high, as it indicates that the company is keeping its costs low while maintaining a high interest in its products.

An Alternate Method

The numbers route is not the only way to determine which stocks are a smart decision for the value investing strategy. Some investors instead choose to invest in the companies they believe in on a values level. It is also known as values-based investing.

For example, an investor may not support oil companies due to their drilling methods but strongly supports alternative energy methods. This type of investor would choose to invest in those companies who build windmills, solar panels, and other new alternative energy products.

With this investing strategy, the current market and individual company's performance does not influence the investor's decision. The investor's personal values and beliefs direct the stock purchases.

Factors to Consider

There are many reasons a stock could be undervalued, including the following:

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