How to find Value Stocks? When are Value Stocks in demand?
In the world of investing in individual stocks, there are two broad categories to select from. Value stocks and Growth stocks. What we want to pay attention to when distinguishing one or the other, is calculating the intrinsic value.
There are two ways to calculate Intrinsic Value.
- Discounted Cash Flow (DCF)
- Dividend Discount Model (DDM)
While Discounted Cash Flow and Dividend Discount Model are intended to calculate intrinsic value, there is another popular method to identify value stocks. This is called Peer Analysis.
Peer Analysis would include ratios to compare to competitors, industry averages and the index average. Although this is a popular way to find intrinsic value, there is a negative to this method that I will point out later in this post.
Intrinsic value is the value of a company and their stock price. It is determined through fundamental analysis and ignores the stocks market value. It is pretty much selecting a value without any outsider influences or concerns. You are giving the stock a completely true value of what is worth based on all the aspects of the individual company.
Ignoring the stocks market value is key when calculating the intrinsic value, but for an investor to understand if the stock is considered a value stock, you must see where the company is in the market after calculating the intrinsic value. Say you calculate the intrinsic value of Apple, and the fundamentals say the company should be trading at $150.00, and it is actually trading for $140.00. Then it looks as this is a good time to buy. Many of the Dow30 companies are value stocks. Apple is trading less than its intrinsic value at the moment, so you should highly consider purchasing it at a discount after taking all other considerations.
Fundamentals of a company include things like their dividends, earnings and sales numbers. If the stock is trading below what the fundamentals are saying it should be, consider this to be a value stock. Performance is a key indicator in determining this.
Mature companies are those that are usually value stocks. Therefore, many of the Dow 30 companies are value stocks. Value investors seek stocks that they believe the market has undervalued. But there is one pitfall you want to always keep in mind when trying to select value stocks. They call this the value trap.
Watch out for the Value Trap!
The value trap is when a stock looks like it is trading at a discount to peers and looks cheap. BUT, it very much should look that way. Reasons being that their fundamentals aren’t up to par compared to their peers. Understanding why a company’s fundamentals are a way they are will help you to seek out companies that should be or shouldn’t be trading above or below their intrinsic value. Don’t let a competitor to a company that you believe is awesome let you think it is awesome too because it is trading around the same price. You really need to dig deep and find the fundamental differences and where each company should be truly valued at.
Warren Buffett & Value Stocks
There is one good quote to keep in mind…. Warren Buffet once stated “In the short run, the market is a voting machine. In the long run, it is a weighing machine.” This should be used when you are trying to figure out if you calculated the intrinsic value correct. If you did, in the long run it will eventually work out for you. Don’t pay attention to actions in the short run of a stock if you calculated the intrinsic value to a number that isn’t working out for you just yet. In the short run, people in the markets can be irrational.
There are a few common characteristics of value stocks that many investors look for. These are a high dividend yield, low price-to-book ratio or a low price-to-earnings ratio.
Warren Buffett is a big believer in Value investing. He follows the Benjamin Graham school of value investing. One way to put this, they are bargain hunters. When you picture Buffett, picture a person grocery shopping with more cut out coupon than items in their shopping cart. Buffett does not really pay attention to the actions of the market at all. He pays a close attention to the potential of the company, holds them for a long-term play and that is what has made him BILLIONS. Buffett has owned shares of Coca-Cola since 1988, when he bought more than $1 billion. This was a prime example of a value investment. After the stock market crash of 1987, Buffett saw the potential and understood the fundamentals of Coca-Cola. He believed the company’s value was higher than where it was being traded in the market at that time, so he took a shot. And now the rest is…..HISTORY!