Every day, anyone who follows the stock market’s news feed is bombarded with articles about value investing. Titles about value investing include: “Top values stock to buy”, or “7 Value Stocks Warren Buffett Wishes He Could Buy”. With all this talk about value investing, you may wonder how could there be so many good deals on the market? You also might be wondering what is value investing?
Value Investing is the idea that a stock is underpriced, and you’ll be able to make profitable investments by finding undervalued assets(stocks).
Before we explore if or why there are deals on the market we have to understand what undervalue means.
The truth is there are hundreds of ways you can determine any stock to be “undervalued”. This makes it so pretty much every stock is undervalued one way or another. Two of the most common methods are using the P/E ratio and book value.
P/E ratio or price over equity ratio is a common metric used to understand the value of a stock. This ratio tells us how many times a company’s shares are traded compared to its earnings. If a company earns $1 per share and trades for $2 per share the P/E ratio would be 2/1 or 2. After you find the P/E ratio, you can compare that to the P/E ratio of other stocks in the industry to see if it’s undervalued.
The book value of a company is the total value of all the assets on a company’s balance sheet. The obvious flaw with using the book value is that companies will do everything they can to inflate losses for tax purposes and may have intangible assets like patents or copyrights which do not have a value on paper. There are also supercomputers and teams of Ph.D. people with Billions of dollars who will have a much more accurate understanding of what the real values of the company are. It’s hard to imagine that an average investor can find a good deal without the big time investors scooping it up first 1.
The truth is there are probably not any deals on the stock market. Whenever you think you found a deal it is likely because you do not understand the risks.
The semi-efficient market hypothesis is the idea that the stock market is priced with all public data. It is true that there are frequent exceptions to this rule but most of them cannot be proven in the moment meaning if there is a big drop in the market it is just as likely that a lot of stocks are going to be trading at the new ratios then it being some sort of panic. Stocks trade and move at random prices. It is very difficult to know why the market is currently expecting a certain price for the stock is because it believe with all the public information available that is the right price. Many may point out anomalies like those firms which beat earnings do not outperform firms those who meet expectations. There is a lot of data that suggests that there are other external factors that caused this and therefore not a undervaluation issue2.
If one finds a stock priced cheap it is more likely that the market perceives some type of risk than the stock being undervalued. For example, you can look at a company like Bank of America(NYSE: BAC). Let us assume the company has an amazing financial statement and you can see lots of good signs from all the data you can find. If you do not know anything about how interest rates work or have an idea of how likely they will change you cannot begin to understand the risks the company has.
The important takeaway is to not go deal hunting. It is unlikely that you will be able to spot a deal and if you think you see a deal it is likely because of some external factors. Even if you do a lot of research on a stock and believe it should be worth more it doesn’t matter as the only thing that is important is if everyone else thinks it is worth more. If you are banking on some change in the company like surprise growth in profits that is not value investing that is making an assumption about the company.
Being that most investors have no idea about risk or pricing stock, investing in stocks is often closer to gambling than investing. If an individual does not follow or understand all-important financial metrics do not begin to try to value stocks as it will be useless. Even if you do know how to do all that it is not clear that the market will agree with your pricing.
Good question! While there may be tons of unknown risks for each stock there is less risk in investing in large indexes or entire markets. It seems likely that the companies will continue to improve by adding more services, creating new inventions, and making their business more efficient. You can never rely on one company to stay at the top or stay growing but you can rely on the entire economy/market. One should invest in broad market ETFs(an ETF is an index of funds where instead of buying a share of one company you buy a small percentage of shares of many stocks). The risk of investing in large portions or entire markets is that the entire economy will fail and at that point either way the money is useless. It is not hard to imagine that the economy will grow, there may be risks in investing in broad market ETFs but overall this investment is understandable, safer, and has plenty of potentials.
Disclaimer: I am not a financial advisor and this should not be considered financial advice.