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Value Investing 101: How to Spot Shares with Intrinsic Value

Introduction

Benjamin Graham is the father of value investing and is credited with developing strategies for value investing. Graham shared these strategies in his book, ‘The Intelligent Investor,’ which even Warren Buffet follows. It continues to guide investors wanting to realize the potential of stocks priced lower than their intrinsic value. It means undervalued stocks or stocks selling at a discount.

Research and Ranking, a share market advisory, offers some insights into value investing. To know how to pick undervalued stocks, one has to understand the intrinsic value.

What is Intrinsic Value?

Intrinsic value is the actual value of a share. It is the price of a share without the impact of all external factors. It is the price considering only the fundamental aspects of the stock. Intrinsic value is based on the earnings, dividends, growth potential, and the company’s financial health.

It is important to note that the intrinsic value is estimated or a hypothetical value.

By knowing the intrinsic value, an investor can gauge whether the stock is over- or – undervalued.

Intrinsic Value: Why Is It Important?

Intrinsic value is a reference point to assess the possible returns and risks associated with an investment. It helps investors gain long-term success and stability in the stock market. As it has no connection with the market price of that stock, the intrinsic value can provide a solid foundation when making investment decisions.

The intrinsic value can help an investor identify the growth potential and financial strength of the company they wish to invest in.

What is Value Investing?

Value investing is a strategy for the long term, focusing on less popular stocks in the investor community and the market. It is an approach where investors look for stocks of companies trading below the intrinsic value by taking a contrarian stand to the market. Investors buy a stock undervalued by the market and hold it until it reaches or exceeds their true worth.

Value Investing Strategies

The following are the value investing strategies that investors follow to know the best shares to buy:

Fundamental Analysis: Look for consistent revenue growth, profitability, and financial position by studying the company’s financials, such as profits, revenue, assets and liabilities, and the growth potential from the financial statements.

The margin of Safety: Value investors purchase securities when their market price is significantly below the intrinsic value. It is the difference between the inherent value and the market price. The margin also serves as a buffer against significant losses.

Believe in the Business You Wish to Own: An investor should have immense faith in the business they are buying. One should be very passionate about the business they want to invest in.

Invest in a Business You Understand: Invest in a business you understand rather than because you like it. It will help you make informed and educated estimates about the business’s future earnings.

Invest in a Well-managed Company: A business with a well-managed leadership adds value and credibility to a company’s stock. Warren Buffett advises seeking an integrity, intelligence, and energy management team.

Look at The Earnings Quality, Dividend History, and Competitive Advantage: Companies with consistent earnings, a track record of growing dividends, and the potential to have a competitive edge over competitors hint at a solid and long-term intrinsic value.

Avoid Value Traps: Stocks of cyclical industries may show undervaluation, and thus a decline in earnings, when a downturn is imminent. Industries whose intellectual property rights for patents are soon to expire or tech disruptors facing stiff competition can lose value and thus become value traps.

Be Patient: Value investing requires patience and is a long-term strategy. It may take a considerable time for the market to recognize the actual value of some stocks. One must understand that value investing is taking a contrarian stance.

Five Metrics to Pick Stocks with Intrinsic Value

Price-Earnings Ratio – This is a company’s stock price ratio to its earnings per share (EPS). It indicates investors will pay for each unit of earnings generated. Comparing a company’s P/E ratio to the industry peers or historical averages helps determine if the stock is undervalued or overvalued.

Price-Earnings Growth Ratio- This is a better measure of the PE ratio. It enables an investor to assess a stock’s valuation by considering the PE ratio and expected earnings growth rate. Considering the company’s potential for future earnings growth, the PEG ratio gives a more comprehensive view of a stock’s valuation.

Price-To-Book Ratio – The price-to-book ratio measures the value of a company’s stock price to its assets. A stock is undervalued when the price is lower than the value of the assets. Here, the assumption is that the company is not in financial hardship.

Free Cash Flow – The firm can generate free cash flow after meeting all obligations and incurring capital expenditures. The availability of free cash flow enables a company to invest in the future growth of the company, pay off debt, pay dividends, and issue share buybacks.

Debt-to-Equity Ratio – The debt-to-equity ratio helps investors determine how a company finances its assets. A lower debt-to-equity ratio implies less reliance on outside finance.

Conclusion

The strategy behind investing in value stocks is to make profits with minimal risk. Even with various tools and methodologies available to assess a stock’s valuation, value investing is a mix of art, science, and skill that only improves over time. Nevertheless, value investing is a timeless approach.

Sources

https://www.investopedia.com/terms/v/valueinvesting.asp#toc-intrinsic-value-and-value-investing

https://www.investopedia.com/articles/fundamental-analysis/09/value-investing.asp

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