How intrinsic value helps with value investing
Have you ever bought something at a discounted price? If you did, what can you say about the product's quality? Is it the same, or does it have lesser quality? This is the logic that we will be using today for our main topic: value investing.
What is value investing?
In value investing, the investor picks out the stocks that look like they are trading at a considerably lesser value than their intrinsic or book value. In a nutshell, value investing means that investors look for stocks that look underestimated for their actual worth. Hence, buying this stock is like buying a quality stock at a discounted price. One of the most significant factors on why this happens is a market reaction - and they tend to be exaggerated. And these reactions to good and bad news lead to price movements that do not match a company's long-term fundamentals. This is a situation that value investors are looking for.
Let us go back to our earlier comparison.
Earlier, we are talking about buying products that are on sale. Let us say that you want to buy a smartphone. However, you wait for sales like the Black Friday sale. You know that the value of the phone that you will buy at a discounted price and the original price has the same quality. Does it make sense to pay more if you can get something of the same quality at a cheaper price if the need is not urgent? However, here is the catch: you are clueless about when and where the sale will happen. These sales will not be posted anywhere.
We can compare this to a situation that may happen in the stock market. There are times when a stock price declines even when the company's value remains the same. This is an excellent opportunity to buy a valuable stock at a cheaper. However, you also do not know when these situations happen. Hence, you need to be resourceful to see this kind of information. Because if you do, then you might be in for a great opportunity.
Undervalued stocks and intrinsic value
We have mentioned the term "intrinsic value" earlier. It is a combination of the use of financial analysis and fundamental factors. When we say financial analysis, we refer to financial performance, revenue, earnings, profit, cash flow, and the like. On the other hand, fundamental factors refer to business models, company brands, target market, competitive advantage, etc. Value investors will try their best to figure out a stock's intrinsic value. They need to know if it is undervalued, reasonably cheap, or deeply discounted for their value. Some of the metrics that investors use include:
- Price-to-book (P/B). It is also known as the "book value." It measures the company assets' value while comparing them to the stock price. The stock is undervalued if the company is not in financial turmoil, but the stock price is lesser than the company assets' value.
- Price-to-earnings (P/E). It shows a company's earning track record to help an investor determine if the stock price does not reflect the earnings (undervalue).
- Free cash flow. It is the amount that the company produced from its revenue or operations minus the costs of expenditures.
Why use a metric?
Those mentioned are just some of the metrics
that anyone can use. But why use a metric? It helps a value investor decided
whether to buy the shares or not. These metrics will show if the stock's
current price and its intrinsic value are attractive enough.
