Think about your favorite ice cream shop. Between mint chocolate chip, salted caramel, and the classic vanilla, there are lots of flavors to suit different tastes, right? It’s the same when buying stocks.
You can choose between buying a value stock or a growth stock, a large cap or small cap. Stocks that pay a dividend and stocks that don’t. It’s enough to give you brain freeze if you’re still learning the ropes of investing.
Value stocks might catch your eye if you’re looking for investments you can buy and hold for the long term. But what exactly is a value stock and is it something you should invest in?
This primer offers an introduction to the basics of value investing so you can decide if it’s the right strategy for you.
What is a value stock?
In a nutshell, a value stock is one that’s perceived to be currently undervalued in the stock market. That doesn’t necessarily mean these are cheap or low-priced stocks. Instead, it means that value investors believe the stock’s share price doesn’t accurately reflect its intrinsic value.
Your next question might be, what determines a value stock’s intrinsic value? Generally, value stock investing is about finding stocks that share these things in common:
- Strong financial performance
Undervalued stocks tend to have solid fundamentals. That means that when it comes to things like revenue, dividends, earnings and profit margin, they perform well compared to similar companies.
- More assets than liabilities
Value stocks also tend to have good balance sheets, with more assets than debts. A value stock can also have an equal balance between equity, or ownership in the company, and debt.
- Underpriced relative to competitors
A signature hallmark of a value stock is a share price that’s lower than its competitors that have a similar financial profile.
- Lower price to earnings ratio
The price to earnings ratio is a technical investing term and it’s essentially a way to measure a company’s value. This ratio compares a company’s share price to its earnings per share. Value stocks have a P/E ratio that’s typically in the bottom 10% of the stock market.
- More likely to pay dividends
A dividend payout represents a percentage of a company’s earnings. Since value stocks are often older, more established companies, they may be more likely to pay a dividend to their investors.
Value Stocks vs. Growth Stocks
The things that help define a stock as a value stock are also what help to set it apart from growth stocks. But just what is a growth stock?
Simply, it’s a stock that’s deemed to have above-average growth potential. Growth stocks can be smaller or newer companies that have a shorter track record than value stocks. They’re less likely to pay a dividend to investors, because any profits are usually reinvested in growing the company. Growth stocks can offer a high return potential if the stock takes off, but they can also be riskier than value stocks because they are less proven.
Growth stock investing is often focused on making some quick gains by buying shares of a company that’s in growth mode. If growth happens quickly and the stock’s price rises, investors can reap the benefits when they sell their shares.
The Benefits of a Value Investing Strategy
Value investing isn’t a fly-by-night strategy. In fact, it’s an investment style adopted by Warren Buffett, who’s used it quite successfully throughout his investing career.
The most important thing to know is that buying value stocks is all about the future payoff. The idea is that if you buy undervalued stocks now and hold on to them for a decade (or two or three), the stock’s value will have increased by the time you’re ready to sell. It’s the embodiment of the age-old investing rule: buy low and sell high.
Value stocks can be very rewarding from a return perspective if you’re patient enough to wait out the market. Dividends are a plus. You can use them as an income stream or reinvest them. If you invest in a value stock that pays dividends and reinvest in additional shares, you can increase your position without having to invest any new money out of pocket.
Compared to growth stock investing, value stocks can be less volatile because the companies they’re associated with have been around for a while. Some value stocks can also be blue chip stocks, meaning they’re larger companies that are household names. These value stocks can cost more per share but if they’re undervalued, you could still realize a tidy profit when you sell.
How to Invest in Value Stocks
If you’re thinking that value investing is something you’d like to explore, you’ll need to do your homework. That means reading up on a stock’s fundamentals.
Fundamentals means things like the P/E ratio, how much debt a company has relative to its assets, the earnings per share, whether it pays a dividend and if so, the dividend yield. The goal is to get a broad view of how a company’s stock share price measures up compared to what it’s actually worth.
Like any other stock, remember to weigh the risks alongside the potential for rewards. When you invest in value stocks, the biggest risk is that the market’s assessment of the stock’s value sticks. In that scenario, the value may not increase much, if at all, which means you may not get the returns you’re looking for.
That’s where diversification becomes important. Diversification means balancing out risk and reward in your portfolio by including different investments. You could invest in real estate, for example, to help manage value stock risk. Or you might buy shares of growth stocks to hold alongside your value stocks to boost your portfolio’s overall return.
Just like that make-your-own sundae at your local ice cream parlor, with Ally Invest Self-Directed Trading, you have the flexibility to decide exactly which value stocks or growth stocks suit your tastes.