Value Investing: Beginner's Guide to Finding Undervalued Companies
Investors use many different strategies to select the stocks and other securities they’ll use to build their portfolios.
One popular approach (championed by big names like Warren Buffett and Peter Lynch) to choosing companies to invest in is called value investing.
Value investing relies on the belief that investors can research companies to determine their true value and that the market value of businesses may differ from their true value.
Investors aim to purchase shares in undervalued companies and sell those shares after their market value rises.
This strategy gives investors the chance to buy strong companies at a low price, which can generate significant returns.
However, choosing the wrong companies could lead to low growth or even losses from the investor’s portfolio.
Common Indicators to Identify Undervalued Companies
With any investing strategy, investors have to put in the effort to research potential investments and do their due diligence.
This is especially true for value investors, who have to find companies that are undervalued by the stock market.
With so many companies in the world, it’s impossible to do your due diligence on every single one of them.
To help narrow down their options, many investors use a few indicators to screen for companies that may have the potential to grow.
These are some of the most popular indicators that people use to screen for value investments.
Low price-to-earnings ratio
A company’s price-to-earnings (PE) ratio is the ratio between its share price and its earnings per share.
In general, the higher the company’s PE ratio, the more growth investors expect out of the business. With a high PE ratio, investors have to pay more for every dollar of earnings the company produces.
Value investors look for lower PE ratios because it means that they can purchase the same amount of earnings at a lower cost as buying a company with higher PE ratios.
Low price-to-book ratio
A company’s price-to-book ratio looks at the company’s share price as compared to its book value per share.
A company’s book value looks at its underlying assets, minus its liabilities.
If a company is trading at or below a price-to-book ratio of 1, then the company is trading at its book value or less. Value investors usually look for companies with a price-to-book ratio under 1.
High dividend yield
Dividends are regular cash payments that companies make to stockholders.
Many investors seek out dividend-paying companies because they want to produce income from their portfolio.
If a company has high dividend yields, investors can recoup their investment through the cash payments more quickly than by buying shares with low yields.
They can also reinvest the dividends to purchase more shares.
While investors often view dividends as reliable sources of income, companies can change their dividends at any time.
A very high dividend yield can also be an indicator of financial distress, so value investors need to be careful about focusing too much on high yield companies.
Increasing earnings per share (EPS)
A company’s Earnings per Share (EPS) simply compares the company’s earnings to the number of shares outstanding.
If a company is increasing its EPS on a consistent basis, investors may feel confident that it will continue to grow and gain value in the future.
Free cash flow
Free cash flow measures a company’s cash flow from operations minus any capital expenditures it makes.
It measures how efficiently a company can generate cash that it can devote to returning to shareholders in the form of dividends or share buybacks.
Value investors want to buy shares in companies with higher levels of free cash flow because those businesses can return more of the money they make to investors.
Just looking for the good things can paint companies in too positive a light.
It’s important to also look for negatives or counterindicators to make sure that potential investments are truly a good idea.
High Price to Earnings (PE) ratio
Companies with a high PE ratio are usually companies that are poised to grow rather than established businesses selling at a good price.
While growth investments can be a good option for some investors, if you’re trying to buy undervalued businesses, a high PE ratio is a bad sign.
Any company with high levels of debt can be a risk. Even if the company’s current cash flow can pay these debts.
Eventually, the debts will come due and the company will need to pay those debts, either by increasing their revenues or by reducing the value they return to shareholders.
Investors want to see consistent growth in a business, as that’s one of the ways that companies can increase their stock values.
This is true for both growth and value investors. Falling earnings are a bad sign for a company and indicate that it needs to change its strategy.
Even if a company is undervalued according to other indicators, decreasing earnings may indicate that its stock price will continue to fall.
Recent change in management
The management team of a company can play a major role in its success.
Strong, effective management can increase a business’s efficiency and help it grow. Poor management can squander opportunities for growth and resources.
If a company has recently changed its management team or is changing management frequently, that may be a sign of internal trouble. Even a new management team may not be able to overcome these obstacles.
Value Investing Options
If you’re interested in value investing, there a few paths that you can take, each with pros and cons.
Many investors like to invest in individual companies.
This is one of the most difficult ways to invest.
People who buy shares in individual companies have to research dozens of different stocks and analyze them to see if they’re good investing opportunities. If you make good choices, you can build a strong portfolio and experience significant gains.
However, choosing the wrong stocks can lead to significant losses.
When investing in stocks, building a diversified portfolio is essential.
If you put all of your eggs in one basket and the stock performs poorly, you could lose a significant amount of your portfolio. If you hold many different stocks and one performs poorly, better performance from the others may make up the difference.
Keep in mind:
When investing in individual stocks is that some brokerages charge commissions or other fees for each transaction. This can add additional costs when you’re building your portfolio.
Value mutual funds
Mutual funds make it easy for people to build diversified portfolios while only buying shares in a single fund.
There are thousands of mutual funds out there, each with its own investing strategy.
There are many funds that focus on value investing. You can research the many different value-focused funds.
By buying shares in one fund, you can get exposure to dozens or hundreds of stocks at once, even if you don’t have the money to buy one or more shares in each of those businesses.
One of the drawbacks of mutual funds is that there’s a cost to investing in them.
Funds charge a fee, called an expense ratio. The fee is quoted as a percent of the amount you invest that you pay each year. For example, if you invest $10,000 in a mutual fund with a 1% expense ratio, you’ll pay $100 in fees each year to own the fund.
Even small fees can have a significant impact on your returns over time, so you want to find a fund that charges low fees.
Exchange-traded funds (ETFs) are similar to mutual funds.
The primary difference is how they’re traded.
Transactions in mutual funds happen once per day after the market closes. ETFs are traded on the open market during normal trading hours. This makes ETFs more suitable for investors who want to actively trade their shares.
Another difference is that mutual funds also tend to have minimum investment requirements. Investing in ETFs can let investors avoid those requirements.
Most brokerages only let investors buy whole shares, so if an ETF is worth $50, you can only invest in $50 increments.
With a mutual fund, investors can add to their investment in whatever increments they desire.
When to Sell
When you sell an investment, whether it’s stocks or a mutual fund, is a difficult decision.
The reality is:
There’s no single correct answer.
No matter when you sell shares in a company, those shares could go on to gain or lose value.
When you’re value investing, one sign you may want to sell is when a company stops showing signs of being undervalued.
This may mean increasing PE ratios or decreasing EPS.
If a company is starting to trade closer to or above its book value, some value investors will take that as a sign to sell.
Capital Gains Taxes
When you sell an investment for a profit, you incur capital gains taxes. The taxes you have to pay will vary with how long you’ve held the investment.
In general, holding an investment for longer will reduce the taxes you pay.
Short-term capital gains taxes are charged against any profits on investments held for one year or less.
Short-term capital gains are taxed just like your ordinary income.
That means that you’ll pay higher taxes if you have a higher income.
Long-term capital gains taxes are charged on profits from investments owned for longer than a year.
These rates are lower than the short-term capital gains rate, so it can sometimes be worth holding an investment for slightly more time to take advantage of the lower tax rate.
Before You Start Value Investing
Before you start investing, regardless of your investing strategy, there are a few things you should take care of first.
For example, you should make sure that you have an emergency fund. Everyone should have some cash saved up to cover unexpected expenses like medical bills or car repair bills. Common advice is to have between 3 and 6 months’ expenses saved, as this will cover even major problems like job loss.
You should also take advantage of tax-advantaged space, such as your 401(k) or IRA.
Saving in these accounts reduces the taxes that you have to pay which can save you a lot of money in the long run.
Once you’ve taken care of these basics, you can start thinking about using a value investing strategy in your taxable brokerage account.
Remember that all investing is subject to risk, so only invest money that you can afford to lose and take steps to reduce your risk, such as by building a diversified portfolio.
You'll need a brokerage account
To invest, you’ll need to open a brokerage account. There are many companies that offer brokerage accounts, but not all of them are made equal.
Look for a brokerage with low or no account maintenance fees and no trade commissions.
If you want to invest some of your money in mutual funds or ETFs remember that many brokerage companies offer their own funds and offer perks for investing in those funds.
You might want to choose a brokerage based on your desire to invest in its mutual funds.