FUNDAMENTAL ANALYSIS- VALUE INVESTING STRATEGY
Value investment strategy usually deals with finding companies that trade below their intrinsic value, that is, stocks that market has undervalued. Investors who tend to believe in this strategy claim that markets react to good and bad news which thereby leads to fluctuations in the prices, not correlating with long term fundamentals of a company. When price starts to fall for a temporary period, investors find this opportunity to make profits, assuming that fallacy will be corrected in valuation by the market.
Value investors do not believe in buying stocks because they are cheap, they consider the cheap price along with the fundamentals. That is, value investors tend to find stocks with strong fundamentals such as earnings, dividends, book value and more. They buy those stocks at discount, always considering their quality and fundamentals.
For example, let’s suppose Company A and Company B that have been trading for the last year at 20 per share. Eventually, for both the companies, share price falls to 10 per share. This fall would not mean that both companies are trading at a bargain or discounted rate. If an investor gets attentive to both the companies, he may notice that Company A possess strong fundamentals and good management team, on the contrary, Company B has been afflicted by poor earnings and poor management skills. Hence, with strong fundamentals, low price tends to be temporary, thus company A proves to be an ideal investment option for value investors. On the other hand, low price with weak and poor earnings imply that prices will fall further in future, making Company B unsuitable for value investors.
It is, however, known that value investors invest or buy a stock in order to be an owner of a company. Value investors believe in making profits by investing in companies with fundamentals and not by trading. External factors such as market volatility and price fluctuations that may have an impact on companies are not considered by value investors, as they approach methods of examining the value of the underlying asset. External factors are not taken into consideration by value investors since these factors are not believed to leave an impact on the company for a long term and hence when evaluating fundamentals, are usually ignored.
Investors find stocks on any stock exchange platforms, however, value investors can include the following in their strategies and should find companies with:
- A share price which is no more than two-thirds of intrinsic value. For instance, the share price should be no more than Rs.20 if intrinsic value is Rs.30.
- A low price-earnings (P/E) ratio. The P/E ratios indicate the current price of a company in respect to per-share earnings. It is computed by dividing market value per share by earning per share. Value investors are advised to look for stocks that have P/E less than 40% of the stock’s highest P/E in the last five years.
- A low price-to-book (P/B) ratio. This ratio is used to make a comparison between stock market value and its book value. It is computed by dividing the current closing price by book value per share of the recent quarters. Value investors should look for companies that have P/B ratios falling below industry averages.
- A low price/earnings to growth (PEG) ratio. Stock’s value with considering a company’s earnings growth is measured by this ratio. Dividing stock’s P/E ratio by growth of its earnings for a given period gives PEG ratio. Value investors should look for companies that have PEG ratios below one.
- A low debt/equity (D/E) ratio. D/E indicates the financial leverage of a company. This ratio is calculated by dividing total liabilities by stockholder’s equity. D/E should be used by investors only to compare companies that fall in the same industry as high D/E can be normal in one industry whereas low D/E can be normal in another one.
- Earnings growth of at least 7%. Along with the earnings growth, declining earnings of 5% or more for more than 2 years, considering the last 10 years should not be considered.
MARGIN OF SAFETY
It can be said that value investing succeeds only when an intrinsic value calculated is exact. Investors can find this value by themselves or by any online source but they are advised to give a margin of safety such as if you have very well calculated the intrinsic value of a company to be Rs.30 per share, then you may use Rs.25 in your analysis. A margin of safety helps you avoid paying more for a stock even when the intrinsic value of a stock is less than you computed.