The Motley Fool

What You Need To Know About Value Investing

There are a few different investing styles that investors can adopt, and each has its own advantages and disadvantages. However, the most important thing for us to do as an investor is to pick one that we feel most comfortable with. That’s how we can sleep soundly at night.

The few investing styles I am referring to are: income investing, growth investing, and value investing. In this article, I will be focusing on value investing. For more on growth investing and income investing, head here and here.

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At the core of value investing is the idea of buying an asset that is currently priced under its intrinsic value, and selling the asset when its price approaches or runs above its intrinsic value. What this also means is that the intrinsic value of a stock and its price are not always the same – it is this discrepancy that allows value investors to make money.

The intrinsic value of a stock can be calculated with several different metrics. Perhaps the most commonly used is the price-to-earnings (P/E) ratio. It is calculated by dividing the price of a stock by its per share earnings. In general, the lower the ratio, the more attractively priced the stock is.

Another metric that is commonly used is the price to book (P/B) ratio. The math involved is also simple – we take the price of a stock and divided it by its book value per share. The book value of a company reflects the value of its assets, less all liabilities. In a similar manner to the P/E ratio, a low P/B ratio typically signifies a better deal. And if a stock has a P/B ratio of less than 1, the company is theoretically worth more dead than alive.

The two-metrics mentioned above can also be used together with a concept called the margin of safety. Simply put, the margin of safety is the idea of giving ourselves room for error when investing. This means that if we think the proper P/E ratio for a stock is 8, we should buy it at a P/E ratio of well below 8.

Many of the all-time greatest investors, such as Benjamin Graham and Warren Buffett, have built their fortunes and reputations on the principles of value investing.

Value investors, however, must keep the “value trap” in mind. Value traps are stocks that appear cheap because they have very low P/E and P/B ratios. But in reality, their business prospects are declining at a furious rate. It’s also important to watch out for distortions to the P/E ratio – a stock can have an attractive P/E ratio because of a large one-off gain that boosted its earnings temporarily. As such, the use of low P/E and P/B ratios should only be a starting point – albeit an important one – in the search for investment opportunities.

Having looked at the three different styles of investing (again, here are the links for growth investing and income investing), investors must take it upon themselves to find out which style suits them best. This would then help guide their investment decisions. Investors should also keep in mind that changing styles is not a sin. It is very likely to happen as we move through different phases of our lives.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.