Value investing is all about finding the diamonds in the rough. Here's how to spot them.
Value investing definition
Value investing is a stock picking strategy where you buy stocks that you think are worth more than their current price. Value stocks are companies whose share prices are lower than they “should” be, judging by metrics such as earnings per share.
Some value investing strategies involve buying stocks that have fallen out of favor with investors, in the hope that their strong financial fundamentals will propel a rebound in their share prices.
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How do you find value stocks?
Value investors use a variety of metrics to identify bargain-price stocks. Michael Chomiak, an investment manager and financial advisor at Access Wealth in East Hanover, New Jersey, says that the price-to-earnings ratio, or PE ratio, is one of the most important.
A stock’s PE ratio is its share price divided by its earnings per share over the last 12 months. “The higher the number, the more expensive the [stock] would be,” he says.
Chomiak says that value investors typically look for stocks with PE ratios below 14, which is usually less than the S&P 500 index’s PE ratio.
» Check out: How to research stocks
He says that positive free cash flow, another measure of profitability, is another good thing to look for when identifying value companies.
“Positive cash flows give them the opportunity to reinvest in the business, to do buybacks, and to increase dividends,” Chomiak says.
Other signals that value investors look for include low debt-to-equity ratios and high return-on-equity ratios. All of these metrics can be found on an online broker’s stock screener, or on a website like Yahoo Finance.
Should you start searching for value stocks?
Whether or not you should invest in value stocks depends on your investing goals and how much time you have. Value investors are bargain hunters who use metrics like PE ratio and free cash flow to identify cheap stocks with long-term potential.
This kind of investing often involves a lot of time-consuming research. It also usually means buying individual stocks, which can be pricey.
A different approach could be investing through funds. Index funds are baskets of stocks included in one investment, and they may offer steadier returns with less maintenance and a lower upfront cost. You can even find value index funds that focus entirely on value stocks.
» Learn how to buy stocks
Value stocks vs. growth stocks
Value stocks are often contrasted with growth stocks, whose appeal is based on rapid increases in earnings or revenue.
“Generally, value stocks have better fundamentals than growth stocks,” Chomiak says.
“They’re usually more mature businesses that pay steady dividends, and that have free cash flow,” he says.
Given its focus on consistent fundamentals and comeback stories, value investing tends to be more long-term-oriented than growth investing. Legendary value investor Warren Buffett once wrote that “our favorite holding period is ‘forever.’”
Chomiak agrees. He says value stocks “are more of a consistent grower over time than growth stocks.”
» Learn more: Value vs. growth stocks
