When the stock market has big swings, many investors rush to sell and get out of the market. Value investors know better, and look at volatile times as opportunities to pick up stocks at a discount. (See also: Tutorial: Value Investing.)

Search for Stable Companies

Value investors understand that some companies are resistant to economic conditions. For example, consumer staples companies like Proctor & Gamble Co. (PG) and Unilever N.V. (UN) sell products that people need no matter what happens at their jobs.

Grocery chains, gas stations, and utilities are other great industries to search. Again, these companies offer something that people need and use every day. We cannot live without groceries, transportation, and electricity in our homes.

Find Undervalued Stocks

In all market conditions, the core of value investing is to find undervalued stocks. Value investors look at company fundamentals to find the intrinsic value of the stock, and use that number to make investment decisions.

When economic news leads investors away from stocks, the entire market tends to decline. However, just because the price of a stock changed does not mean that the company’s fundamentals have shifted.

If you can find a stock that is worth $20 per share and now trades below $20, you have an opportunity to make a profit. To determine the value of the stock, you can use common proven techniques including the following:

Net Present Value Analysis

In a net present value analysis, investors project the future free cash flows of the company and use a formula to calculate the net present value of those cash flows. The resulting enterprise value is divided by the number of shares, and gives you a target stock price.

Of course, this is not a simple task. Wall Street analysts make their entire careers attempting to perfect the models to best project free cash flow and risk for companies to calculate the most accurate intrinsic value. (For additional reading, see Valuing Firms Using Present Value of Free Cash Flows)

Multiples Analysis

In a multiples analysis, investors compare financial performance of companies in the same industry to identify which may be overvalued and which are undervalued.

Popular ratios used to compare companies include price to earnings and price to book value. In the first example, investors compare the stock price to the company’s earnings per share. If the share price is $5 and earnings per share are $1, the P/E ratio is 5. If other companies in the industry have a higher average P/E ratio, you may have found an undervalued stock.

The same logic is used across other multiple valuation methods. (For more, see Equity Valuation: The Comparables Approach)

Capital Asset Pricing Model

The capital asset pricing model is a formula that provides an expected rate of return on a stock. If that rate of return is higher than is your own hurdle rate (your minimum required rate of return), it is a potential good buy.

The formula requires some assumptions, which are not as clearly defined as those used for other analysis methods. However, if you have good information and understand market performance and the risk of the company, measured using beta, you can quickly identify profitable investment opportunities.

Pick Up Quality Stocks at a Temporary Discount

When the market is in a pattern of positive and negative swings, you may be able to scoop up shares of a value stock at a price not typically available. Using the same techniques described above, you can calculate the value of stocks for a personal watch list. On a down day, you may be able to snag that stock for a gain where that opportunity does not typically exist.

Remember that the price of a stock does not necessarily equal its value. While the efficient market theory would lead one to believe otherwise, in real markets there are constant inefficiencies, and those lead to investment gains.

It may take quite some time for a company’s share price to reach its intrinsic value, which is why value investors focus on long-term gains rather than short-term market fluctuations. A volatile market is simply a better opportunity to buy shares at a discount.

Do Not Sell Your Stocks

Because value investors focus on long-term gains, getting scared and selling is the wrong thing to do. Famous value investor Warren Buffet once said to “be fearful when others are greedy and greedy when others are fearful.”

Volatile markets drive many investors to the sidelines because they are afraid of losses. That is the exact time you should start looking for deals, not quickly unloading your portfolio.

History suggests that investors who sell when the markets begin to crash do often preserve capital in the short-term. However, missing out on the market recovery and significant gains that often follow leave the sellers well behind those who wait it out.

Value investors do not look at their own stock performance many days because they do not worry about day-to-day volatility. Over many years, stocks tend to always go up. Sure, there are some exceptions, but keeping a well-diversified portfolio protects you from those losses.

Consider Index Funds

To protect yourself from the volatility of individual stocks, another great option is to buy a low fee index fund such as an S&P 500 index fund. When you do, you are betting on the entirety of the market, not just a single company.

Investors and fund managers benchmark their own performance against these types of funds, and most of the time the market wins. Over the long-term, the stock market as a whole has recovered from every depression, recession, and period of market volatility to reach new highs.

The S&P 500 has a compound annual growth rate of around 10%. Many stocks do not achieve the same results, and for investors without the ability to invest in a large, diversified portfolio, S&P 500 index funds may provide the safest way to sustained returns.

The Bottom Line

Volatile markets are a scary time for uneducated investors, but value investors focus on the long term. Do not rush to exit the market. Instead, look for opportunities to buy stocks at a discount. If you do, when the market recovers you will enjoy gains for years to come.

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