What Is Value Investing?

Value investing is an investment strategy where stocks are picked based on the fact that they appear to trade for less than their intrinsic or book value. Value investors actively ferret out stocks they think the market has undervalued. Investors employing this strategy believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond to a company's long-term fundamentals. This overreaction offers value investors an opportunity to profit by buying stocks at discounted prices.

Noted value investment gurus Warren Buffett and Peter Lynch are both known for analyzing financial statements and looking at valuation multiples, in order to identify cases where the market has mispriced stocks and capitalize on reversions to the mean.

Value investors assume the efficient-market hypothesis is false and that stocks don't always trade at intrinsic value.

How Value Investing Works

Undervalued stocks are thought to come about through investor irrationality, from which value investors hope to profit, by investing in companies which may exhibit below average valuation multiples, such as price-to-book (P/B) and price-to-earnings (P/E) ratios.

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. In fact, 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 levels. Value investors require some room for error in their estimation of value and will seek to purchase shares they perceive to be deeply discounted.

Key Takeaways

  • Value investing came from a concept by Columbia Business School professors Benjamin Graham and David Dodd in 1934.
  • The strategy includes buying stocks that are underpriced, and therefore trade at less than their intrinsic value.
  • Berkshire Hathaway leader 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. 

Requirements for Value Investing

To utilize a value investing strategy, one must assume the efficient-market hypothesis is false, which says that all available information is already priced into the cost of a stock. Based on a value investor’s perspective, stocks may be over- or underpriced for a variety of reasons. Psychological biases can push a stock price up or down based on news, such as disappointing or unexpected earnings announcements, product recalls or litigation. Stocks may also be undervalued because they trade under the radar, and are consequently inadequately covered by analysts and media outlets.

Value investing is a subjective process. Some investors who look only at existing financials, don't put much faith in estimating future growth. Other value investors focus primarily on a company's future growth potential and estimated cash flows. Despite different approaches, 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.

One-Third

Value investing guru Benjamin Graham argued that an undervalued stock is priced at least a third below its intrinsic value. 

The Art of Value Investing

The key to buying an undervalued stock is to thoroughly research the company and make common sense decisions. Value investor Christopher H. Browne recommends asking if a company is likely to increase its revenue via the following methods:

  • Raising prices on products
  • Increasing sales figures
  • Decreasing expenses
  • Selling off/closing down unprofitable divisions

Browne also suggests studying a company's competitors, to evaluate its future growth prospects. But the answers to all of these questions tends to be speculative, without any real supportive numerical data. Simply put: there are no quantitative software programs yet available, to help achieve these answers, which makes value stock investing somewhat of a grand guessing game. For this reason, Warren Buffett recommends investing only in industries you have personally worked in, or whose consumer goods you are familiar with, like cars, clothes, appliances and food.

Another strategy involves buying companies whose products or services have been in demand for a long time, that are likely to remain popular over the long haul. While it's difficult to predict when innovative new products will capture market share, it's easy to gauge how long a company has been in business and study how it has adapted to challenges over time.

Couch Potato Value Investing

Couch potato investing is a passive strategy of buying and holding a few low-cost index funds that invest in stocks and bonds. Becoming a couch potato value investor entails buying and holding a limited number of low-cost value investing vehicles for which someone else has already done the investment analysis.