Oct 10, 2023
What Are Value Stocks?
Value stocks are shares of companies selling at bargain prices that investors expect to rise because the company’s financial fundamentals suggest the shares are actually worth more than the current value. These stocks appear to be undervalued, and value investors aim to reap returns when the market realizes their worth and drives up the stock price in the future. And because most value stocks pay dividends, investors can make money on their investment even while the price remains lower.
If you’re considering investing in stocks, value stocks may offer a high-yield investment option with relatively lower volatility and risk than growth stocks. And in contrast to most other stocks, value stocks often show better performance during periods of rising interest rates and inflation.
Key characteristics of value stocks
Current market conditions determine whether a stock is deemed a value stock, and that classification can change over time. Before purchasing, consider factors like stock price, dividend yield, P/E ratio, and other performance indicators to help determine if a stock falls into the value stock category.
When considering stock price as a value investor, it’s helpful to understand the difference between fair value and market value. Fair value is the measure of an asset’s intrinsic worth, including its growth potential. Market value is the current value of the investment as determined by actual transactions on the stock market. Fair value changes slowly, while market value changes frequently due to supply and demand. Value stocks tend to be undervalued, or priced lower than their intrinsic worth, based on key indicators of a company’s future financial performance. Keep in mind that value pricing might be a bargain, but that doesn’t necessarily mean it’s cheap.
Price-to-earnings (P/E) ratio
The P/E ratio tells you what investors are paying for each dollar of the company’s earnings. Investors generally see lower P/E ratios as an advantage, and value stocks tend to have P/E ratios lower than comparable companies in the same industry.
Price-to-book (P/B) ratio
Book value is the amount of money that would be left if the company liquidated and paid off its debts. The P/B ratio shows the relationship between stock prices and book value; it’s calculated by dividing the market price per share by the book value per share. A P/B ratio of less than 1 suggests that a stock may be undervalued and, therefore, potentially a value stock.
Price/earnings-to-growth (PEG) ratio
The PEG ratio looks at the P/E ratio relative to the company’s earnings growth, usually over the last 12 months. Examining the PEG ratio can help determine whether a stock is truly undervalued or if it’s bargain-priced due to low growth potential. A PEG ratio of less than 1 often indicates a truly undervalued stock.
Free cash flow (FCF)
Companies use some of their available cash that’s not needed for capital expenditures to return value to shareholders in the form of dividends and buybacks or to repay debt. The FCF is determined by subtracting a company’s capital expenditures from its operating expenses. Value stocks should have a rising free cash flow.
Debt-to-equity (D/E) ratio
The D/E ratio is best used to compare value stock prospects with competitors since acceptable debt-to-equity ratios vary by industry. This ratio describes a company’s reliance on external financing, so a lower ratio indicates a better chance that a stock is a value stock. The D/E ratio is calculated by dividing total debt by total shareholder equity.
Though not all stocks pay dividends, value stocks frequently do, and the dividends can be relatively high. If the dividend yield is higher than the historic or industry average, you might be looking at a value stock.
Value stocks vs. growth stocks
In short, value stocks are considered undervalued, while growth stocks are seen as overvalued. While value stocks are expected to rise based on anticipated future performance, growth stocks are already rapidly increasing in value. Value investors are banking on the future growth of an undervalued stock. Growth investors, on the other hand, are usually willing to pay higher prices, incur more risk, and sacrifice dividends in the hopes of riding the wave of a stock that’s already priced high and still climbing.
Key differences between value and growth stocks:
- Price: Growth stock prices are generally higher than comparable companies, while value stocks are trading at a lower price than competitors.
- P/E ratio: Growth stock P/E ratios are generally higher than their value stock counterparts.
- Risk: Growth stocks are generally more volatile, leading to higher risk of rapid swings in price. Value stocks, in contrast, tend to be more stable, with share value changing more slowly over time. Investors with higher risk tolerance may feel comfortable with the risks of growth investing, while conservative or moderate investors may prefer value investing.
- Dividends: Growth companies generally don’t pay dividends because retained earnings are usually invested back into the company. On the other hand, value stocks usually offer relatively high dividends.
Pros and cons of value investing
A value investing strategy hinges on buying undervalued stocks that will increase in value because of a company’s potential to perform well in the long term. This strategy can produce rewards if the company bounces back as anticipated. However, if the anticipated increase in share price doesn’t happen, you may not see the returns you were hoping for.
Advantages of value stocks
- Potential to buy at a bargain: Buying a less expensive, undervalued stock could yield higher returns if it regains value in the long run.
- Can be lower risk than growth stocks: Growth stocks tend to be volatile, but the relative stability of value stocks can make them a lower-risk investment.
- Potential to earn dividends: Value stocks generally pay out dividends, which provide steady income and increase the total return on your investment if the share price also rises.
Disadvantages of value stocks
- Price may not rise as expected: There are no guarantees in the stock market. A value stock’s price might not increase, especially if a company doesn’t perform as well as investors predict.
- Potential for value traps: Some stocks might seem like value stocks due to their bargain prices, but the issuing company may have significant issues that undermine financial performance. Identifying value traps can be tricky, so research each individual stock thoroughly.
- May have lower growth: Value stocks generally have less potential for substantial growth than more volatile growth stocks, especially in the short term.
How to invest in value stocks
It takes time, effort, and close analysis to seek out value stocks. There are no hard-and-fast rules for deciding if something is actually a value stock, so investors must carefully evaluate the company’s financial outlook for each individual stock they’re considering. It can seem overwhelming, but these resources can help.
- Consult the Russell 1000 indexes, which establish benchmarks and track performance of large-cap value and growth stocks.
- Look for undervalued stocks by comparing earnings ratios, market cap, price, and overall financial health with competitors in the same industry.
- Consider more established companies with large market cap. Look for companies that have traditionally had stable stock price increases but currently seem undervalued.
Are value stocks right for your portfolio?
Depending on your time horizon and risk profile, value stocks might be right for your portfolio. But keep in mind that value investing doesn’t have to be the only strategy you use. Maintaining a diversified portfolio that includes a balance of value stocks, growth stocks, and other securities like mutual funds, exchange-traded funds (ETFs), and bonds can help you reduce your overall investment risk and maximize your returns.
Investing made easy.
Start today with any dollar amount.
How to Start Investing: A Comprehensive Guide for Beginners
How To Invest in the S&P 500: A Beginner’s Guide for 2024
Mutual Funds vs. Stocks: Which Is Better for Beginner Investors?
Stock Market Holidays 2023 (Including 2024)
The Stash 100: Money tips everyone needs to know
What is a Brokerage Account, and How Do I Open One?