What is 'Value Investing'
Value investing is an investment strategy where stocks are selected that trade for less than their intrinsic values. Value investors actively seek stocks they believe the market has undervalued. Investors who use this strategy believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with a company's long-term fundamentals, giving an opportunity to profit when the price is deflated.
BREAKING DOWN 'Value Investing'Undervalued stocks come about through investor irrationality. Typically, value investors seek to profit off this irrationality by selecting stocks with lower-than-average price-to-book ratios, lower-than-average price-to-earnings ratios and/or higher dividend yields. These numbers are compared to a company's intrinsic value, after which, a value investor invests if the comparative value is high enough.
However, there is an issue with value investing in that estimating the intrinsic value of a stock is difficult. Two investors can be given the exact same information and place a different value on a company. For this reason, another central concept of value investing is that of "margin of safety." Value investors need to buy an equity at a big enough discount to allow some room for error in the estimation of value.
Additionally, value investing is subjective. Some value investors only look at present assets and earnings and do not place any value on future growth. Other value investors base their strategies completely around the estimation of future growth and cash flows. Despite the different methodologies, the underlying logic is a value investor should buy something for less than he thinks it is currently worth.
An Example of a Value Investment
Value investors seek to profit from market overreactions that usually come from the release of a quarterly earnings report. On May 4, 2016, Fitbit released its Q1 2016 earnings report, and saw a sharp decline in after-hours trading. After the flurry was over, the company lost nearly 19% of its value. However, while large decreases in a company's share price are not uncommon after the release of an earnings report, Fitbit not only met analyst expectations for the quarter but even increased guidance for 2016.
The company earned $505.4 million in revenue for the first quarter of 2016, up more than 50% when compared to the same time period from one year ago. Further, Fitbit expects to generate between $565 million and $585 million in the second quarter of 2016, which is above the $531 million forecasted by analysts. The company looks to be strong and growing. However, since Fitbit invested heavily in research and development costs in the first quarter of the year, earnings per share (EPS) declined when compared to a year ago. This is all average investors needed to jump on Fitbit, selling off enough shares to cause the price to decline. However, a value investor looks at the fundamentals of Fitbit and understands it is an undervalued security, poised to potentially increase in the future.