What Is Value Investing?

Value investing is an investment tactic where stocks are selected which appear to trade for less than their intrinsic, or book, values. Value investors actively seek out the stocks they believe the market has undervalued. Investors who use this strategy think the market overreacts to good and bad news, resulting in stock price movements which do not correspond to a company's long-term fundamentals. This overreaction gives the value investor an opportunity to profit buy stocks at a deflated price.

Warren Buffett, Peter Lynch, and other successful investors focused on value investing in identifying investment opportunities. By reading through financial statements, they seek to identify cases where the market has mispriced stocks and capitalize on the reversion to the mean.

Finding Value Investing Targets

Undervalued stocks are thought to come about through investor irrationality. Value investors hope to profit from this sort of irrationality by investing in companies which may have any combination or one of the following:

  • Below average price-to-book ratios
  • Lower than average price-to-earnings (P/E) ratios
  • Higher than average dividend yields

After a review, the value investor will then decide to purchase shares if the comparative value is attractive enough.

However, this task is not so easy in practice. Estimating the true intrinsic value of a stock is more of an art than a science. Two different investors can analyze the exact same valuation data on a company and arrive at different decisions. Because of this, value investors often set their own "margin of safety" based on their particular risk tolerance. Value investors require some room for error in their estimation of value and will seek to purchase shares they perceive are deeply discounted.

Value investing is a subjective process. Some investors will look only at existing financials and do not put much faith into estimating future growth. Other value investors will focus primarily on future growth potential and the company's estimated cash flows. Despite different strategies to the approach, the underlying logic of value investing is to purchase assets for less than they are currently worth, hold them for the long-term, and profit when they return to the intrinsic value or above.

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Key Takeaways

  • Value investing came from a concept by Columbia Business School professors Benjamin Graham and David Dodd in 1934.
  • Warren Buffet is perhaps the most well-known value investor.
  • Studies have consistently found that value stocks outperform growth stocks and the market as a whole, over long time horizons.

Real World Example

Value investors seek to make a profit from market overreactions which usually come from the release of the company's quarterly earnings report. In November 2016, Fitbit (NYSE: FIT) released its Q3 2016 earnings report and saw a sharp decline in the after-hours trading of its stock, at one point dropping 30% in under 10 minutes, as reported by Fortune. After the flurry was over, the company had lost nearly 19% of its value.

However, while significant drops in any company's stock price are common after an earnings release, in this case, Fitbit met the consensus expectations for the fiscal quarter and even increased its guidance for the following year.

The company earned US$505.4 million in revenue for the first quarter of 2016, up more than 50% when compared to the same period from one year earlier. Further, Fitbit expects to generate between $565 million and $585 million in the second quarter of 2016, which is above the $531 million forecast of analysts.

The company looks to be healthy 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 the previous year. This news was all average investors needed to jump on Fitbit, selling off enough shares to cause the price to drop. However, a value investor will look at the fundamentals of Fitbit and understands it is undervalued, poised to increase in the future, potentially.