Value investing is the habit of purchasing stocks which are undervalued at the present moment.These are like discounts in the market.For example, if the rate of the certain product is Rs.100 and you are getting the product at a rate of Rs.60 seeing a discount of 40%.You sell the product at the product’s original price of Rs.100 in the end. This is value investing.
Many value investors are known such as Warren Buffet and Benjamin Graham.In a short you want the intrinsic value of a stock to be more than the price in which you buy the stock.Value investors beat the market by identifying the stock which is trading at a discount. There are various ways to find the stocks which are trading at a discounted rate.
When is a stock Undervalued?
A stock can get undervalued by different means.People generally buy and sell stock by seeing the momentum of a stock.If the price of a stock is rising, generally they buy a stock and they sell when the price of a stock is declining.When they see that the market is advancing, they don’t want to be left out and they buy.They sell in panic when the market in crashing.They do not analyze the fundamentals.Such psychology can affect the stock prices to get either overvalued or undervalued.This psychology leads to market crashes.
1.Market crashes-During the times of tech boom, intrinsic due to market psychology there were very high levels of over investing which rocketed the stock prices beyond its intrinsic value.When the highs began to f all, the markets began to react panicking and a sell-off took place.Due to market panic, there was a market crash.This took the prices of the stock below their intrinsic value creating an opportunity fo value investors to buy the securities at a discounted rate.
2.Bad News from a reputed company-When a bad News from a reputed company comes in, the market psychology is to sell the stock lead to the significant lowering of stock prices.Examples are the recent drug banning by USFDA for pharmaceutical companies.A value investor purchases the stock of that company when everyone is selling in the panic.
3.The Stock is unnoticed-There are many scripts in the stock market which are not very well known.They are not household names.Due to this, the stocks are undervalued as they are away from notice.A value investor identifies such stocks and makes a profit.
4.Does not meet Analyst’s expectations-There are a lot of times when analysts go wrong.And the earning for the quarter does not meet their expectation. On such situations, the market might sell the stocks in panic creating opportunities for value investors.
How to find stocks which are undervalued?
First, you should screen the stocks which you want to investigate.Then you should try to analyze all the financial data that is available for the company.This is eased now because of the internet, as all the information is now available.There are a lot of websites which aggregate this information.Or you can visit the company’s website to find.All major website provide information about the current stock quote, from earnings per share and all the news about the company.The insider trading information can also be for the exchange website.
According to one of the greatest investor of all time Benjamin Graham, the undervaled stock should currently quote at one-third the price of it’s intrensic value.We can perform the following simple calculation to find stocks which are undervalued:
1.P/E Ratio-This can simply be found by deviding the share price by the EPS(Annual earnings per share).The P/E ratio should be low preferably in single digit.This number that we get after deviding is known as earnings multiple.Suppose a stock is currently trading at Rs.80 and the EPS is Rs .10, so the earning multiple will be around 8.Usually it will be a good bye.
2.Earnings Yield-Earning yield is the reciprocal of earnings multiple expressed in percentage.Let us elaborate this with an example.Suppose the earnings multiple is 5.The reciprocal of 5 is 1/5 which is 0.2.If we express this in terms of percentage, then it comes out to be 20%.So 20% is the earnings yield.We want the earnings yield to be high for value investing.A high earnings yield convey that the earnings are high compared to the share price.
There are other ways to find stocks which are good for value investing.This does not require any math but you require to be skillful in finding stocks for value investing.This require you to do a bit of research.
One such research based finding is insider purchasing.Insiders are the company’s senior manager or directors who are owning stock equal to or more than 10%.Usually if a company’s prospects looks good to a manager or director, they will be purchasing stocks in large quantity.As these managers or directors has unique knownledge about the company, it is a good bet to buy these stocks.
But the reverse might be not true i.e. if the insiders are selling stocks in large amounts,that dosen’t mean a doom.They might be selling stocks for personal reasons.They may require cash for any personal reason.But if mass sell off by insiders are taking place then you must go for another in depth research to find out the reason for sell off.
Picking stocks for value investing is a form of an art than a science.If it were science then people can plugin all the ratios in a software and the computer would have analysed the thing.It requires some critical thinking.You should ask youreslf some of the questions such as-Can the company increase the revenue by raising the prices?Increasing sales?Lowering the expenses?Growning the company?Selling the loss making division of a company?Who are the company’s competitors and how strong are they?
Warren Buffet suggests to invest in the companies that you understand.If you are currently working in a pharmaceutical company, it is better to buy pharma stock as you already know how the pharma company works.This will help you analyse the company better than others.