What Is a Value Stock? Definition and Investing Strategy

Value stocks are waiting for their time to shine.

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What Is a Value Stock?

A value stock is a stock whose current share price is trading below its intrinsic value—for whatever reason. The market perceives the stock’s fundamentals, such as its earnings, P/E ratio, and book value, as less solid than its peers and so is priced accordingly. Unlike growth stocks, value stocks tend to be older, more established companies whose shares are trading at bargain prices.

Value investing is a strategy that lets shareholders buy a stock with the expectation that it will appreciate over time as the market factors in both the company’s overall health as well as its potential.

Interestingly, value stocks have historically outperformed growth stocks partly because they usually offer dividends, or cash payouts. It’s kind of like a company’s way of rewarding investors for their patience as well as assuring them that they’ll be around for the long haul.

Knowing how to analyze the specific characteristics of a value stock can help savvy investors spot an investment opportunity, which we’ll get into below.

What Determines a Stock’s Value?

Simply put, a stock’s value is determined by the simple rules of supply and demand: supply of shares available and demand for shares. Value investors seek inefficiencies in the market that cause truly valuable companies to be priced at less than what they’re worth.

One way to examine a stock’s value is through fundamentals like its price-to-earnings ratio, which is a metric which evaluates a stock’s current price by its earnings per share. A value stock has a P/E ratio that is lower than the general market, and that’s actually a good thing. Generally speaking, the lower the P/E, the better, because that means you are paying less for every dollar of earnings.

Why Do Value Stocks Usually Offer Dividends?

Value stocks typically sport a dividend, or a regular cash payout to shareholders from the company’s profits. Dividend payments are usually made on a quarterly basis, although special dividends can happen at any time. Why would a company offer a dividend? The answer is that since these companies tend to be more advanced in their business cycle, they simply don’t need to reinvest all of their profits.

A company’s dividend yield, expressed in percentage terms, illustrates how much of a payout a company gives shareholders relative to its share price.

If a company’s dividend yield is 10%, and you own $10,000 of stock, then you would receive an annual payout of $1,000 (or $250 quarterly). 

What Is the “Value Premium?”

The larger historical returns that value stocks can deliver over growth stocks is known as the Value Premium. Some of it has to do with the dividend payment, as mature companies incentivize investors as a way to compensate them for the risk they are taking by buying shares. In addition, offering a dividend is one way for a company to appeal to investors even though it is experiencing sluggish earnings growth, which would have an effect on its share price. 

How Do I Value a Company’s Stock?

For investors on a quest for the “diamond in the rough” stocks—value stocks about to soar—there are three common techniques they can use to identify stocks with high intrinsic value:

One way is through fundamental analysis, which uses quantitative metrics to find the true worth of a stock. These metrics include price-to-earnings ratios, price-to-book value, debt-to-equity ratios, and projected earnings growth, to name a few.Another way is through the dividend discount model (DDM), which assumes that the present value of all future cash flows can determine the intrinsic value of a company. This is a good method for evaluating blue-chip (large-cap) stocks in particular.If the company has experienced a leveraged buyout, valuations can also be made based on cash flow, or earnings before interest, taxes, depreciation, and amortization (EBITDA).

Who Is the Greatest Value Investor?

There’s nothing cheap about Warren Buffett, who has amassed a fortune exceeding $100 billion. A businessman and philanthropist, Buffett generated his wealth through value investing by finding companies to invest in that were trading far below their intrinsic value and then holding them for the long term. In 2013, Buffett published his investing fundamentals in a letter to shareholders of his company, Berkshire Hathaway.

His main takeaways were:

You don’t need to be an expert to be a successful investor.You should focus on a company’s long-term earnings potential—he says if you can’t calculate its 5-year returns, then you shouldn’t invest in it. Don’t speculate. Buffett’s investments include established businesses like textile companies, insurance businesses, and consumer goods manufacturers.Don’t get caught up by emotion-based selloffs or listen to the pundits who say they know what the market will do next. Whenever he hears them, Buffett says, “I am reminded of Mickey Mantle’s scathing comment: ‘You don’t know how easy this game is until you get into that broadcasting booth.’”

What Are the Top Value Stocks Right Now?

As the economy has slowed from the threat of multiple COVID variants, certain sectors, such as communications, utilities, and health care, have trended higher. Utilities and healthcare are typically value sectors that can withstand market corrections.  TheStreet.com’s Brian O’Connell explains how one key value metric can help you uncover hidden gems. 

What Is the True Value of a Stock?

Value investors like Warren Buffett do not believe in the efficient market hypothesis, which assumes that stocks are efficiently priced at all times. Therefore, they seek to identify the “true value” of a stock by examining its fundamentals. One of the most popular methods to do so is by examining the price-to-earnings ratio (P/E ratio).

A great way to value a company is through its P/E ratio

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Should I Invest in Growth or Value Stocks?

Growth or value? Which type of stocks you should invest in all depends on what kind of investor you are and what your risk tolerance is. Generally speaking, investing in a mix of value and growth stocks is a healthy investment strategy, as, taken together, they make up a balanced portfolio. Sometimes, the business cycle favors growth, while at other times, value leads. Owning a healthy mix could increase the likelihood that an investor achieves more consistent returns over time.

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