Value investing can be challenging. Investing in value stocks has disadvantages and risks. However, when done right, choosing and holding the right value stocks through thorough fundamental analysis and research can mean substantial gains for value investors.
Key Characteristics of Value Stocks
A Quick Guide to Picking the Right Undervalued But Promising Stocks
The central characteristic of a value stock is that it appears undervalued. However, not all undervalued stocks are value stocks. Remember that picking the right value stocks involves performing research and some form of fundamental analysis. The following are the specific characteristics of value stocks:
1. Low Price-to-Earnings Ratio
The price-to-earning or P/E ratio is a financial ratio for valuing a particular company by measuring its current share price relative to its earnings per share. It indicates what the market is willing to pay for the current operations as well as the prospective growth of the company. Value stocks appear to be undervalued because of their low P/E ratio.
2. Low Price-to-Cash Flow Ratio
Another ratio for stock valuation is the price-to-cash flow or P/CF ratio which is calculated by dividing the market capitalization of a company by its operating cash flow in the most recent year, or by dividing its per-share stock price by its per-share operating cash flow. Some value stocks can have a low P/CF ratio because they are currently undervalued.
3. Low Price-To-Book Ratio
Some value stocks can also have a low price-to-book ratio because it is another financial ratio used for stock valuation. This ratio compares the current market value of a particular company to its book value. Buying a stock for less than the book value of its issuing company can create a margin of safety for value investors.
Considering Value Stocks and Value Traps
Tips for Spotting and Choosing the Right Value Stocks
Other characteristics of value stocks include stock prices that are lower than the stock prices of companies operating within the same market or industry. Companies with unsatisfactory reports, legal problems, or public controversies tend to trade undervalued stocks because of the negative perception of the public and the community of investors about their long-term prospects. Some of these stocks are potential value stocks.
Most value investors use a “Dog of the Dow” investment strategy that includes purchasing the top 10 high-yield dividend stocks in the Dow Jones or other related stock indices at the start of each. These investors then adjust their stock portfolio continuously the following year in an attempt. This portfolio adjustment is called rebalancing and its purpose is to maximize the investment returns of a particular stock portfolio.
Note that picking the top 10 highest dividing-yield stocks is based on the notion that the companies that use and trade them are near the end of their business cycle. Their stock prices are either low or their dividend yield seems higher due to their low stock prices. Nevertheless, upon picking these companies and once they rebound back to the highest point of their business cycle, their stock prices would increase faster than other companies.
Of course, one of the pitfalls of value investing is the susceptibility to value traps or picking undervalued stocks that do not appreciate in accordance with expectations. The common characteristics of value trap stocks include low stock prices accompanied by extended periods of low multiples, as well as financial instability, prolonged historical underperformance, and minimal growth potential of the issuing companies.
