What is value investing in the stock market and how it works

Every stock has two prices: the intrinsic value and the market value. Value investing is an investment strategy in which investors buy stocks that is trading at a price lower than the estimated intrinsic value.

Intrinsic value is known as the company’s true worth. Whereas, market value is the price which other people are willing to pay for the asset at any given moment. You need to know both the prices in Value Investing.

In Value investing, investors will look for stocks which are trading below their true worth so that they can compare it with the market price. Therefore, the most important thing you should calculate is the stock’s true worth.

In other words, in value investing, investors always try to resolve the difference between company’s true worth and market price.

Investors following this principle are known as value investors.

These investors are more concerned with the business and its fundamentals such as sales and earnings growth, cash flow position, debt-to-equity ratio, Return on Investments and book value.

As per this principle, investing in stock is based on finding what it is worth (intrinsic value) and what is the margin of safety in investing.

Market Price Vs. Intrinsic Value

Stock’s market price is influenced by overall market trend, news, economy and financial issues. Every trading day, Mr. Market will offer you a new price to buy and sell the stock. You are free to ignore or accept the price. The choice is yours.

Value Investor suggests that before accepting or rejecting a price, you should always know the true worth of the company, which is intrinsic value.

Which means you should find stocks that the market has not correctly priced.

By calculating the intrinsic value of a stock you can answer the following two questions:

  • Is the stock available at a bargain price compared to the amount the buyers of the entire company would pay, and
  • Is the stock overvalued

Investors continuously look for stocks that they believe are undervalued by the market or available at a bargain price but have tremendous potential of upside.

Value investing can point you in the direction of good stocks that the market has undervalued.

Calculating stock’s true worth in Value Investing

Investors calculate intrinsic value based on the long-term fundamentals of the company and then compare it to the present market price to know the margin of safety.

In case of high margin of safety, investors buy the stock and sell it when the valuation is high compared to its intrinsic value.

Investors don’t believe in the efficient market hypothesis, which states that stock prices fully reflect all available information due to which it’s impossible to beat the market.

In other words efficient market theory claims there is no rich or cheap stock in the market as stocks are perfectly priced based on the known information.

On the contrary, Investors always believe that the price of a stock can be overvalued or undervalued based on so many factors.

They are concerned with the business and its fundamentals. If fundamentals are sound, but the price is below its true worth, the stock is a good investment candidate.

Fundamentals such as earnings growth, dividends, market share, sales volument over time, price to earnings (P/E) ratio, PEG ratio, debt to equity (D/E) ratio, cash flow and P/B ratio are the most important factor to know how strong the company is and what is its intrinsic value.

When a company’s fundamentals are sound, but the stock is trading below its true worth, the value investors know this is the right investment candidate as Mr. Market has incorrectly valued the stock. When Mr.Market corrects that mistake, price of the stock should experience a rise.

In simpler words, value investing is purchasing stock for less than they are currently worth, hold them for long-term, and sell for profit when they return to the intrinsic value or above.

However, investing for long-term does not mean that you should buy and forget. As a value investor, you should reassess your stock’s value on a regular basis to know whether or not to remain invested.

Here are the ten well known investors of the world:

  • Benjamin Graham
  • Warren buffet
  • Charlie Munger
  • Christopher Browne
  • Seth Klarman
  • David Dodd
  • Peter Lynch
  • Ray Dalio
  • Joel Greenblatt
  • Whitney Tilson

is a fellow member of the Institute of Chartered Accountants of India. He lives in Bhubaneswar, India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.