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Tuesday, August 10, 2010

Understanding Value Stock Investing

Value stock investing is a method that involves purchasing stocks that are going at prices below their worth. Value investors search out stocks the market has under priced. They work on the theory that the stock mark over-corrects in relation to fluctuating economic indicators, thus causing stock price changes that do not reflect companies long term value. Thus value investors seek to to buy stocks when their price is arbitrarily low.

Value investing is a very well known strategy. The theory of value investing was laid out by two Columbia finance professors, Graham and Dodd, in the 1930s. The theory is simple: Buy stocks being sold beneath their real value.

Good earnings, dividends, and cash flow are earmarks of a good company. The value investor hunts for companies that are under-rated by the market currently, and looks to profit when market investors catch on to their mistake and share prices rises.

The potential flaw in value investment strategy is that their is truly no objective intrinsic value to stocks. Individual investors working with the same info constantly take the same information and reckon different values for the same stock. This is why the concept known as “margin of safety” is important in value investing. This indicates buying cheaply enough that a profit will still be turned if one overestimates the ultimate rise in share prices when the market fluctuates. In the extreme case, attempting to practice value investment on such junk assets would amount to throwing money into a hole.

Further, there is no exact, objective definition for “value investing”. A certain percentage of value investors look only at a companies present earnings and assets, ignoring future growth, while other value investors craft a more long-term revolving around potential future growth and profit expansion for the company. The value investor must distinguish between a temporarily undervalued bargain company and one that will simply continue falling in value for the foreseeable future. If company X has been trading for the past quarter at Rs 350 a share but drops to Rs. 150 a share, this is not necessarily a value company. It may simply indicate that the company has problems the market is responding to, indeed, the company in question may be going belly-up.

Here is a rundown of the rules of thumb value investors use for choosing stocks.

1. Price per share must be equal to or less than 66.66% of intrinsic worth.

2. Pay attention to companies featuring P/E rations at the cheapest 10% of traded equity securities.

3. The PEG should be below one.
4. The stock price must be less than or equal to book value.

5. Equity should be greater than or equal to debt.

6. Current assets must be at least double liabilities.

7. Growth in earnings must be at minimum 7% per year, compounded over the previous decade.

Value investing lacks the glamor of the higher risk/reward styles. It relies not on hot tips or intuition, but a simple, cool headed process of screening stocks by the numbers.