What is a Value Stock?

Value stocks are like used cars…

Most of the time, a used car is cheaper than a new one for a reason — It has wear and tear, or it may be damaged and need repairs. It might not be the shiny new thing to brag about to friends, but it’ll do the job, and likely for less money. Likewise, you don’t typically buy value stock because it’s the shiny new thing; you buy it because it’s a good deal that others seem to be overlooking.

A value stock is one that trades at a price below what the company’s performance and or fundamental value suggests it should be worth. Value investing is an investment approach that’s kind of like bargain hunting — You’re trying to find good deals. Value stocks typically have more favorable financial ratios than other companies in the same industry. For instance, if two companies each have the same revenues, costs, assets, and debts, but one’s stock is cheaper than the other, it might be a value stock. In theory, a value stock’s price should eventually catch up to its intrinsic value (which analysts calculate using the company’s financial statements).

Value stocks are potentially lucrative because investors can buy them for less than they are seemingly worth. That’s different from buying a stock because investors think the company will grow. In some cases, a company’s stock is a good value because of a low reputation with investors. Sometimes a negative sentiment may push the price below what the company’s earnings and dividends support. For example, BP’s stock price fell sharply after the Macondo oil spill in 2010. On March 31, 2010, its stock price was $57.07 per share. By June 30, 2010, it was trading at $28.88 — A 49% reduction. On January 31, 2011, BP’s stock price was back up to $47.47. To the extent that investors overreacted to the negative press, some may have looked at BP as a value stock for the period of time in between.

There are many ways that an investor might identify a value stock.

• Earnings per share (EPS): One common approach is to look for high earnings per share, which is the company’s earnings divided by the number of outstanding shares of common stock. In theory, a company’s true worth (aka intrinsic value) is related to its ability to generate revenues. Because net income (revenues minus costs) is the source of dividends (distributions to equity owners) and growth, investors should be willing to pay more per share for a company that has higher earnings per share. If a company’s EPS is higher than other companies in the same industry, it might signal that the stock is undervalued.
• Price-earnings ratio (PE ratio): Another metric that might indicate a value stock is a low price-earnings ratio, which is the stock’s price divided by its EPS. The PE ratio is the number of times the going price exceeds the company’s earnings. If a stock’s PE ratio is lower than that of competitors, that might suggest the company is being traded below the company’s intrinsic value.
• Dividend yield: A high dividend yield (the ratio of dividend payments to share price) may also be a sign of a value stock. It suggests that an owner receives an attractive income, even if the company doesn't see a strong earnings growth rate.
• Book value per share: A company’s book value (its assets minus its liabilities), is found on its balance sheet. The book value per share is what would be left over if the owners liquidated the company (sold all the assets and paid off all the debts). In theory, that amount leftover would get divided across the shares of common stock. Therefore, the book value per share is the theoretical minimum value of a company. If the stock’s price is below its book value per share, an investor might, in theory, make money even if the company goes bankrupt.
• Price-to-book ratio: Another approach is to compare a company's stock price to its book value per share (aka price-to-book ratio). A price-to-book ratio below 1 would indicate that the share price is below the book value per share.

Keep in mind that these are backward-looking metrics, whereas markets usually anticipate future earnings. It’s possible that, when a company that appears to be a value stock, it may reflect the anticipation of poor performance in the future. So while past performance may look good in hindsight, it may not accurately reflect what’s ahead.

In short, a value stock has a price below what investors think current earnings support. A growth stock has a price below what they believe future earnings will support.

Value investors (investors who purchase value stock) try to cash in once the rest of the market realizes its “mistake,” or by collecting dividends that represent an attractive income in relation to what was invested.

Growth investors take a different approach. They look for stocks in which they expect to see above-normal earnings growth. Growth stocks could include a new company that just went to an initial public offering (IPO), or a more established growth company that’s aggressively pursuing new markets.

The billionaire and investor Warren Buffett has described finding value stocks to be like someone digging through the ashtray looking for a cigar with one puff left — It’s not glamorous, but it’s free if you can find it.

The problem is that sometimes there’s a reason that value stocks are cheap. Other investors might know something that hasn’t yet shown up in the financial statements. For example, a company that’s on the verge of bankruptcy, or in the middle of a major lawsuit, might look like a better deal than it is. But if that company ends up bankrupt, it could mean losing the entire investment.

What’s more, value investors don’t usually reap the benefits of a good deal until the rest of the market catches on. It could take several months, or even years, for a stock’s price to recover from a negative experience or another factor that’s holding it down. That’s one reason why value investing is often considered a long-term investment strategy. If it takes too long for the value to manifest, even a very low price could yield a lower annual rate of return that other investments may have provided.

Before you start investing in value stocks, it’s important to know if stocks fit with your goals and then seek to understand how value investing works. It may be helpful to learn more about fundamental analysis — Determining how much a stock might be worth based on the company’s products, sales, management, and other factors.

Keep in mind this axiom: “price is what you pay; value is what you get.” The quote comes from a newsletter written by Warren Buffett, where he explains the philosophy taught to him by Benjamin Graham (aka the father of value investing). What Buffet means is that it’s important to know what a stock is truly worth (aka its intrinsic value) in order to know if you’re getting a good deal.

Typically, an investor chooses to buy a stock when they believe that its price will improve. For value stocks, the choice often comes down to whether an investor thinks the company is currently worth more than its price suggests. For many value investors, that likely means believing in the company itself — Its management, mission, and products.

Value stocks aren’t a flash in the pan, and value investors aren’t usually looking to make a quick buck. Value stocks tend to be financially sound companies that offer a product or service that people know and a brand they trust.