Value investing means buying a stock that an investor believes is undervalued on the assumption that the undervaluation is temporary, and that the stock will eventually reach its full valuation and make the investor a profit. There are several ways to extract value from an undervalued stock.
Analysts and investors create valuation models that help them determine the “fair value” of a stock based on certain assumptions and input data such as current and future earnings or price-to-earnings or price-to-sales ratios. If a stock has a “fair value” of $20, but is currently trading at $10, value investors will buy it, expecting to sell it at a profit when it reaches its full valuation.
Stock prices are determined by supply or demand. If people are rushing to sell in a panic, the amount of stock offered for sale far exceeds the amount of stock buyers can absorb. As a result, stock prices may decline below any reasonable valuation, becoming a bargain; however, many investors fail to recognize it at the time, because they expect things to get even worse, but some astute investors and traders may scoop up the bargains and resell them at a profit when they rebound from the lows.
Some companies may carry assets acquired a long time ago at book value, which does not reflect their present market value. It can be a valuable piece of real estate or shares of another company. On a per share basis, that asset alone may be worth more than the current stock price of the company that owns it. Investors may buy such stocks on the expectation that at some point the stock price will reflect the full market value of the hidden asset. The company may sell the asset for a substantial profit, or spin off the shares of another company it owns to the current shareholders.
Other companies may be grossly mismanaged, but have valuable franchises which can produce a much higher profit if managed properly. A deep-pocketed private investor group may buy shares of such a company cheaply, gain control, fire the management, turn the operation around, and resell the company for a profit when sales and earnings rebound.
Parts Worth More Than the Whole
Under certain market conditions, stock prices can be so depressed that the aggregate value of all the outstanding stock is less than what a company’s assets are worth. A deep-pocketed investor group may buy up the company’s depressed stock, take control, break up the company and sell off the assets at a profit.