Value investing is the strategy of investing in undervalued stocks. Generally, the current market price of a stock is compared with its intrinsic value to decide whether it is undervalued or overvalued. If the current market price is below the intrinsic value, the stock is considered undervalued. The intrinsic value represents the earning potential of the company. Higher intrinsic value than market price of the stock is considered to be an anomaly. It is expected to be eliminated in long term when the company achieves its earning potential, and consequently when the market price converges to its intrinsic value. The popular methods of selecting undervalued stocks is comparing price-to-earning, price-to-book value, price-to-cash flow ratios etc. of the stock with its peers, sector or market as a whole, with lower ratios indicating undervalued stock. For example, Ashok Leyland was a value stock in Feb’14 when its valuation ratios were lower than its peers in the sector.
The concept of value investing was introduced by Benjamin Graham and David Dodd in 1934 through their book “Security Analysis”. It was further developed by Benjamin Graham through his another book “The Intelligent Investor” published in 1949. In this, he advocated the concept of “margin of safety” which calls for a cautious approach to investing. He encouraged picking the stocks trading below their tangible book value as a safeguard to adverse market movements.
The process of picking stocks for value investing is based on the fundamental analysis of the financial statements and other information about the company. The estimation of intrinsic value of a company stock involves judgments on the part of investors/analysts, and different approaches lead to different values. Here comes the importance of margin of safety. If the stock is bought at well below the estimated intrinsic value, the error in judgment might well be covered in case of adverse market or price movement.