What is value investing and how does it work?
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Value investing is a long-term investment strategy that involves finding stocks that appear to be undervalued based on their financial fundamentals. By identifying companies trading for less than their perceived intrinsic value, investors aim to buy low and benefit as the market corrects the price over time.
Here’s a closer look at what value investing is and how you can add it to your portfolio management strategy.
Money.ca takeaways
- Value investing is a strategy that involves identifying and purchasing stocks that appear to be undervalued.
- Investors calculate a stock’s intrinsic value using tools like discounted cash flow models and compare it to the current market price.
- Common traits of value stocks include low price-to-earnings and price-to-book ratios, along with strong financial health and consistent dividend payouts.
- Value investing requires patience, research and a long-term outlook to be successful.
What is value investing?
Value investing is a stock analysis method where investors seek out stocks that appear underpriced compared to their intrinsic value — the estimated true worth of a company based on financial analysis.
For example, if you believe a stock is worth $50 per share but it’s currently trading at $35, you may have found a value investment. The goal is to buy these stocks while they’re “on sale” and hold them until the market catches up.
The concept was popularized by economist Benjamin Graham in the 1940s and has been a core strategy for many successful investors ever since. This strategy relies heavily on data analysis and research — and while it’s not without risk, value investing has been used successfully by renowned investors like Warren Buffett.1
How to invest in value stocks
To better understand how value investing works, here’s an example of how someone could identify a value stock.
- 1. Look for companies you believe in: Start by thinking about well-known companies you use or trust — ones with a strong reputation, steady sales, and a long history. These are often good places to begin your search.
- 2. Check if the stock looks undervalued: Use free tools like stock screeners to compare the stock’s price to its earnings (P/E ratio) or book value (P/B ratio). If these numbers are lower than average for similar companies, the stock might be undervalued.
- 3. Read up on the company's health: You don’t need to dive into full financial statements. Look at summaries on trusted financial websites to check things like: Is the company profitable? Does it carry a lot of debt? Has it paid dividends regularly?
- 4. Compare the price to what it could be worth: If the stock seems solid and you think the price is lower than what it deserves to be, it might be a value investment. You can also read analyst opinions to see how others value the stock.
Understanding the heart of value investing: intrinsic value
Intrinsic value represents what you believe a stock is actually worth based on the company’s finances, performance and long-term potential.
Value investors compare this estimated worth to the stock’s current market price. If the market is undervaluing the company (i.e., pricing it lower than its real value) that’s where opportunity lies.
How do you estimate intrinsic value?
To estimate a stock’s intrinsic value, value investors typically look at:
- Earnings and cash flow. How much money is the company bringing in?
- Assets and liabilities. What does the company own, and what does it owe?
- Future growth potential. Are there signs the company will grow or expand profits over time?
- Industry position and business strength. Does the company have a competitive edge or steady demand?
Once you’ve reviewed these, you can run a simple calculation:
- 1. Say your analysis shows the company is worth $5 billion overall, and it has 100 million shares outstanding.
- 2. Divide the total value by the number of shares:
- 3. $5 billion ÷ 100 million = $50 per share (your estimate of its intrinsic value).
Now, compare that to the market price. If the stock is trading at $35, there’s a $15 gap. That’s your margin of gap, the buffer that gives value investors confidence to buy.
While no estimate is perfect, focusing on intrinsic value gives you a grounded way to make investment decisions based on a company’s real potential, not just market hype.
What is a value stock?
A value stock is a stock you believe is trading at a price below the value implied by the stock’s financial fundamentals. Investors use a variety of methods to identify value stocks.
If you’re early in the stock screening process, some common features of value stocks include:
If you’re early in the stock screening process, some common features of value stocks include:
- Low P/E ratio: The P/E ratio, or price-to-earnings ratio, allows you to compare companies using its stock price and earnings. A low price-to-earnings ratio can signal that a stock is undervalued compared to its industry.
- Low P/B ratio: Price to book ratio helps investors understand how a company’s stock price compares to its net assets. If a company holds many valuable assets and few liabilities, you may find that the company’s book value per share, or assets minus liabilities divided by the number of shares, is more valuable than the current price per share.
- High dividend yield: Dividend yield is the percentage of a stock’s price paid in yearly dividends. A strong, sustainable dividend may indicate a profitable company with long-term appeal.
Value stocks vs. growth stocks
Understanding the difference between value and growth stocks can help you decide which strategy aligns better with your goals or how to balance both in your portfolio.
Value stocks
- Trade below what analysts believe they're worth
- Often come from established companies with stable earnings
- Tend to pay dividends
- Lower price-to-earnings (P/E) and price-to-book (P/B) ratios
- Slower, steadier growth over time
- Found in industries like consumer goods, telecom, and utilities
- Appeal to long-term, risk-averse investors
Growth stocks
- Trade at higher prices based on future growth expectations
- Typically newer companies in fast-growing industries
- Rarely pay dividends, reinvesting profits into growth
- Higher P/E and P/B ratios due to growth outlook
- Rapid revenue and profit increases (but with more volatility)
- Common in sectors like tech, healthcare, and finance
- Appeal to those seeking high returns and can tolerate risk
Value stocks are typically seen as the safer, more conservative choice, while growth stocks carry higher risk but can offer greater upside if the company succeeds.
Example of value investing
Let’s say you’re analyzing a fictional company, TechValue Inc.
1. Assess financial health
First, review TechValue's financial statements. The company has:
- A strong balance sheet with $500 million in cash and only $100 million in debt
- Consistent free cash flow growth over the past five years
- A healthy profit margin of 15%
These factors indicate financial stability and efficient operations.
2. Calculate intrinsic value
Using a discounted cash flow (DCF) model, we estimate TechValue's intrinsic value at $50 per share. The current market price is $35, suggesting a potential undervaluation.
3. Examine valuation ratios
TechValue's key ratios compared to industry averages:
- P/E ratio: 12 (industry average: 18)
- P/B ratio: 1.5 (industry average: 2.2)
- EV/EBITDA: 8 (industry average: 11)
Based on the data from this analysis (with strong fundamentals and below-average valuation ratios), TechValue appears to be a solid value investing candidate.
How risky is value investing?
In general, value investing is considered a lower-risk strategy because it’s based on tangible financial data, not market hype. But that doesn’t mean it’s risk-free. Some common risks of value investing include:
- Stocks can stay undervalued longer than expected
- Companies may underperform or fail to recover.
- The market may never “correct” a stock’s price
In short, value investing is about playing the long game. It’s less about chasing the hottest stock and more about betting on quality companies at reasonable prices — but it still requires discipline, research, and the ability to stomach slow or uneven results.
How well do value stocks perform?
If you pick the right value stocks, you may experience substantial investment returns. But on average, if you look at value stocks compared to the market, you’ll see less dramatic differences in returns.
According to an analysis by Dimensional Fund Advisors, value stocks outperform the S&P 500 by an average of 4.4% annually. Some years are better and some are worse for value stocks. But in the long run, it's better than the typical stock.
Pros and cons of value investing
Pros
- Investment approach based on a company’s financial performance
- Can outperform the market over time
- Less risk than many other investment strategies
Cons
- No guarantees of investment performance
- May underperform during sustained bull markets
- Requires in-depth research and patience
FAQs
Eric Rosenberg
Freelance contributor
Eric Rosenberg is a finance, travel and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full time. He has in-depth experience writing about banking, credit cards, investing and other financial topics and is an avid travel hacker. When away from the keyboard, Eric enjoys exploring the world, flying small airplanes, discovering new craft beers and spending time with his wife and little girls.
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