Not sure how value investing works? Here’s what it is in a nutshell.
Value investing is like going to the flea market and finding a trinket that’s worth thousands of dollars.
In investing territory, that’d be finding stocks that are undervalued and underpriced, trading at prices lower than what they are deemed to be worth. Investors that invest in value stocks look to pay the intrinsic value of the stock — what the stock is worth.
To determine if a company is undervalued, investors will have to analyse the fundamentals of the stock. In this article we look at:
- Why investors opt for value investing
- How do you know a company is undervalued
- What part does value investing play in your portfolio
Why investors opt for value investing
With value investing, investors are not looking for a get-rich-quick strategy. Rather, value investing can help to build a long-term portfolio that is sound and financially rewarding. Of course, that does not mean value investing cannot multiply your portfolio, especially if you buy a stock at a low price and manage to sell it high.
#1 For growth
With value investing, you can find hidden gems at value-for-money prices that can reap you great returns.
The aim is to find these gems that have gone under the radar, before the market catches wind and drives the price up. It’s like finding a hole-in-the-wall cafe that serves great coffee at reasonable prices, before the food bloggers discover it and share it with the whole of Singapore.
#2 For dividends
Not every stock gives out dividends, but of course many would often go for one that offers a high dividend yield relative to its stock price.
Popular stocks such as bank stocks are known for their dividend yield. However, these stocks also do not come cheap, trading at around $10 (OCBC) and $26 (DBS) per share. Besides such popular stocks, there are other companies that give out high dividends as well, such as YZJ Shipbldg SGD and Venture.
How do you know a company is undervalued?
Now that you know value investing is like finding a diamond in the rough, the next question would naturally be: how do you find such companies?
Value investing is a lot of do-it-yourself work. You have to search the deep sea to find the value stocks and make the purchase yourself.
Of course, there are shortcuts to this, be it attending value investing workshops or poring through online materials offered by blogs and websites that have filtered the stocks for you. You can even find ETFs that focus on value investing, such as Vanguard Value ETF, iShares Russell Top 200 Value ETF and Fidelity Value Factor ETF.
The investment metrics
If you’re on the DIY route, you need to understand that value investing relies on fundamental analysis rather than technical analysis. Here are the investment metrics you should be looking out for.
- Price-to-earnings (P/E) ratio
Companies with a low P/E ratio, such as 10 or less, especially compared to their competitors, are usually what investors would flock to. This will help to filter for companies that are trading at a steal relative to its fundamentals.
Popular companies such as Tesla and Shopify are high growth companies that have extremely high P/E ratios. For example, Tesla’s P/E ratio in 2020 was 934.3 while Shopify’s was 477.22. Closer to home on the SGX, Ascendas REIT’s P/E ratio is 24.21 while DBS’ P/E ratio is 14.92.
- Price-to-book (P/B) ratio
A low P/B ratio, such as one that is less than 1.0, provides an indication that it is potentially undervalued. It compares how the company is valued by the market based on the share price, against its book value.
- Price/earnings-to-growth (PEG) Ratio
Value stocks are often companies with high potential for growth. A step up from the P/E ratio, the PEG ratio pegs the company’s value relative to it’s expected growth. This is done by taking the P/E ratio divided by the expected earnings per share growth rate.
The higher the expected earnings growth, the lower the PEG ratio. This helps to take into account the future growth opportunity of the company to determine if it’s truly undervalued.
- Dividend yield
If you’re a dividend investor, look out for a stock’s dividend yield. The dividends you receive should take into account the price you pay for the stock. A high dividend payout per share doesn’t necessarily make the stock a ‘Buy’, especially if it’s trading at high prices. On the contrary, a low dividend payout per share for a cheap stock could provide a higher dividend yield, proving to be more value-for-money.
The higher the dividend yield (as a percentage), the better. The trick is to buy into these high dividend yield companies before other investors discover it, thereby driving up the stock price.
- Earnings-per-share (EPS)
The more shares, the merrier… or is it?
EPS highlights a company’s profitability and is calculated based on the profit divided by the number of outstanding shares. A higher EPS indicates higher profits per share and hence greater value. Value investors can look for companies with a positive and increasing EPS, which shows growth in the company’s profitability.
If you’re still confounded by such investment terminologies, don’t hesitate to check out our SingSaver investment dictionary!
So, where do you find these figures?
These figures can often be found within your brokerage app, or online on websites such as Yahoo Finance, Bloomberg or InvestingNote.
A last note on investment metrics: these aren’t the only figures to analyse. Beyond the five metrics mentioned, some investors go a step further by looking at other fundamentals, such as searching for companies with a low debt-to-asset ratio, looking to avoid companies that are heavily financed by debt.
What part does value investing play in your portfolio?
The answer to this question depends on your risk appetite, personal preference and financial goals.
When deciding on your portfolio allocation, you have to consider how comfortable you are allocating a bigger portion of your portfolio to stocks, since value investing is heavily centred around equities.
To go hand-in-hand with value investing, here are a couple other strategies that you can employ.
#1 Start sooner rather than later
While an attractive proposition, value investing requires time and effort for you to find the companies and eventually enter a position. What you’re missing out on during this waiting period is the opportunity cost of having some of your capital in the market. Starting sooner allows you to tap on the power of compounding to grow your wealth.
However, this doesn’t mean that you should just blindly pick any stock to invest in. To manage both your risk and opportunity cost, you can start investing in an asset class that offers more diversification, at low risk.
For example, this could be opening a portfolio with a robo-advisor, purchasing an exchange traded fund (ETFs), or starting a regular savings plan.
It’s not unheard of for a single stock to catapult your portfolio from rags to riches. There are overnight millionaires that have emerged from the GameStop saga.
However, to rely on a single value stock comes with high risk. You shouldn’t rely on a single stock for investment success, much like how you can’t rely on a single subject to get you good overall grades in school. Rather than keeping your eggs in a single basket, you should diversify your portfolio across asset classes, industries and geographies.
One quick way to get diversification into your portfolio is to go for ETFs. If you’re looking to dabble in multiple different asset classes and geographies, choose to open a brokerage account that offers such access.
Lastly, the topic of value investing can’t go without a mention of renown value investor Benjamin Graham. Beyond this article, bookworms can consider picking up his famous book titled The Intelligent Investor.
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