Value investing is the strategy of finding stocks whose market prices are below their inherent value.  By knowing how and when to watch the market, you can find bargains and make significant profits when the stock returns to its normal levels.  To property execute value investing strategies; there are certain aspects you should seek, while others that you should avoid. 

Invest in the unpopular stocks on the block

Many investors buy stocks when they are going up or when they are currently being favored in the press.  These investors tend to stick to the growth or momentum side of investing, which is different from value investing.  Value investing looks for stocks that are currently not in favor and have fallen below their real worth.

How to find worthy value stocks

The first thing you need to know is where to look for good deals.  A few simple criteria can make value investing a lot easier. 

You can look for stocks that are selling for less than their book value. The book value of a stock is the net value of the company’s assets divided by the outstanding shares of stock.  A quick calculation of the book value from either the company’s filed financial statements or from financial summaries offered at most investment sites, such as www.freerealtime.com or www.motleyfool.com , compared to the market price will identify an undervalued stock.

You can also watch for stocks that are dropping because of a temporary downfall.  The prices have dropped dramatically, but if the financial core of the company is doing well, these stock prices will rebound.  This is where value investors can take advantage of the herd mentality to drop stocks at a sign of a crisis – picking up value stocks at great prices. For example, the recent precipitous drop across the board of financial and bank stocks provided a number of buying opportunities.

Another investment to consider is stocks in the “boring” industries.  These are often ignored by Wall Street, where investors are looking for the next big thing.  For the value investor, the next “big” trend means a higher probability of a mispricing.  With the boring industries, the demand is lower, and thus, it is more likely that you can find a great pricing deal on a stock with strong financials. Also, keep your eyes open for stocks in the same industry as high-flyers. As the old saying goes,” high tides raise all boats”.

The balance sheet is most important to value investors, and you have to have a sharp eye for masked assets.  Some intangible assets will not make it on the balance sheets, and some tangible ones may be undervalued.  Thus, you have to watch the balance sheet with caution – there may be some significant gems that remain hidden because of accounting. Fortunately, there are many eyes on Wall Street and often you can let others do the difficult research and then follow their lead; just don’t wait until everybody jumps onboard, as it may be too late.
Keep your eyes open for insider participation.  Seeing insiders buy large quantities of stock when the price is tumbling is a good sign, since they are closest to the books and their actions often speak volumes.

Is it really a value?

Although financials are incredibly important, you cannot always base the value on low price/book or price/earnings.  You have to consider the business itself as well.  If the company lacks a good business plan, a low price/book could be a sign that the company is about to fold.  You also have to be careful of sectors that are currently popular, since even poor investments will sell when the market is hot.  When the market cools, it does not take long to see which ones were not worth the pricing rally.

Discounted Cash Flow

The Discounted Cash Flow (DCF) valuation model is another tool used to evaluate the pricing range for a stock.  Discounted cash flow looks at the available cash that a company generates and divides the value or multiple of time frame values by a capitalization (or cap) rate. A cap rate is an interest rate that represents the cost of capital and the risk associated with it. 

If you can assume a fair value, then the value assigned to the cash flows may show an undervaluation – giving you a great bargain for value investing.  However, if the parts are significantly undervalued, the company may be more valuable as a sum of its parts. This information is often used by companies to determine if components should be sold or spun off to realize the maximum value. All in all, your primary goal as a value investor is to look for stocks that are selling for less than they are really worth.  If you can learn to read the market and invest at the right time, you will be able to place the risk-to-reward factors in your favor and create amazing returns with value investing.