May 28: The Value Stock Investor: A Long term Investment Strategy

by David Jenyns on May 28, 2007

Value stock investing is for those investors who are interested in the financial workings of the companies in which they buy stocks. This type of investing is based on analyzing the potential for a stock based on its company’s earnings and current financial picture. The key to profiting in value stock investing is finding stocks that are worth more than what they are valued. This only comes from careful analysis of the company’s financial picture. In addition to carefully selecting stocks, the value stock investor is traditionally a buy and hold investor. They invest themselves in the company for the long haul.

The value stock investor does not pay less than $2.00 per share and is not interested in bargain basement stocks. They are looking for diamonds in the rough, stocks that have been inappropriately devalued or have not been recognized for their potential. A stock can become inappropriately devalued when an entire industry is “punished” for one company’s mistake. For example, an oil manufacturer’s ship causes an oil spill and the stocks for all oil manufacturers drop in the following months. Since much of the market is based on investors’ perceptions of stock value, an entire industries’ stock can be devalued from a perceived dip in the value of an industry.

When the market incorrectly values a stock, and there are no fundamental problems with the company, then the market will eventually correct itself to the profit of the value stock investor. To determine the true value of a company’s stock, the value stock investor looks at some fundamental qualities. Earnings growth and cash flow are taken to account as well as book value and dividends. These principles are more important than market factors on the stock’s price.

For investing purposes, the value stock investor will pay attention to several factors. Every investor has an individual formula that works for him or her to determine the value of a stock. A potential investment should have a Price Earnings Ratio (P/E) in the bottom 10 percent of its sector. Price Earnings Ratio is determined by dividing the current price of the stock by the annual earnings per share. A value stock investor may also look for stocks that have a PEG of less than one. A PEG is determined by dividing the P/E by the potential growth. When a stock has a PEG of less than one this indicates that the stock is undervalued.

Additionally, a value stock investor may take a look at the debt to equity ratio of the company. If this ratio is less than one, this is a sign of a potential investment. A price to book ratio (the share price divided by the book value per share) should also be a ratio of one or less.

After looking at the principles mentioned above, the value stock investor determines if the stock is below its obvious value on the market. Again, it must be stressed the value stock investing is not looking for cheap stock alone. It is a combination of researching and determining the actual value of a stock, and looking for a stock listed below value. The value of the stock must be determined first before the value stock investor can decide whether the stock purchase is advantageous.

Determining the intrinsic value of a stock can be the most difficult part for any investor and especially so for the value stock investor. As the market is starting to lean toward non-tangible industries such as technology and knowledge, it is getting more difficult to determine value. There are several websites available that help value stock investors determine the fair value of a stock.

MorningStar.com offers such a service as well as Reuters. It is important to remember to add a margin of error to the intrinsic value found online. For example, if you have determined through your research that the value of the stock is $50, lower your target to $45 per share just in case that projection is wrong.

If you research wisely, buy carefully and hold stocks over the long term, value stock investing can work for you. This philosophy works best if you take the time to do the necessary research and find those diamonds in the rough.

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