What is a Value Stock Worth to Your Portfolio, and How Do You Know When You’ve Found One?
Notice any stocks that are getting pummeled as a result of embarrassing headlines or negative rumors? They might be the next great value stocks. But what is a value stock?
Value investing isn’t as simple as just looking for negative headlines, but that’s sort of the mentality.
“Be greedy when others are fearful,” legendary value investor Warren Buffett once said. His advice still rings true.
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What is a Value Stock Characteristic?
Sometimes good companies get wrongly punished by the stock market, often to the point where they become undervalued. But not just any company receiving a bit of bad news qualifies as a good value play. Instead, value stocks typically share a couple of key characteristics.
Those are:
- Strong growth prospects. Every stock takes it on the chin at one point or another. The companies whose sales and earnings to grow through it all are the ones that consistently bounce back. It doesn’t take much for a stock to get knocked down—a disappointing new product, a scandal involving one of its executives, a bad Super Bowl ad. Those are temporary problems. For savvy value investors, they’re also prime buying opportunities.
- Cheap multiples. There are ways to actually measure value stocks. And it’s not as simple as looking at the price to earnings (P/E) ratio, as some analysts might have you believe. Price to earnings is just one of six valuation benchmarks we use. The others are price to book value, price to cash flow, price to dividends, price to sales and the PEG ratio, which is calculated by dividing the current stock price by the last four quarters of earnings per share growth. For a company to be considered a strong value stock candidate, at least one of those ratios needs to be low. If several of those valuation multiples are low, and earnings are projected to grow, then you may have found a stock that is trading well below its intrinsic value.
Even with those characteristics in place, a successful value investing strategy still depends a lot on timing. You don’t want to invest in a strong value candidate while it’s still in free fall. You want to buy value stocks right around the time they’ve hit rock bottom—or at least close to it.
Determining where that bottom lies isn’t an exact science. Rarely, if ever, are you going to get in at the exact right time. A simple rule of thumb is to adhere to Benjamin Graham’s “Margin of Safety.” Graham, universally recognized as the father of value investing, said the Margin of Safety is achieved by buying a stock only when it’s trading below its maximum buy price, thus minimizing potential losses. The maximum buy price is determined by taking the median consensus high estimate for the stock.
If you understand the answer to what is a value stock, and if investing in value stocks seems promising to you, considering subscribing to Cabot Undervalued Stock Advisor, published by Cabot analyst Bruce Kaser.
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