Every investment model in the stock market starts with owning shares of companies or funds. Value-based investing models provide a strategy you can use to determine which shares to buy, when to hold them and when to sell them. Generally, value investors look to buy shares of companies that they think are selling for less than their actual worth.
Value Investing Basics
The concept of value investing dates back to 1934 when it was coined by Ben Graham. It is a set of rules that an investor can use to look at a stock, considering its value relative to its price. Value investors start by looking at stocks from the perspective of the underlying business, asking themselves what a slice of the company would be objectively worth regardless of the share price. To find shares that trade below the business's true value, they also look for stocks whose prices have been unfairly reduced by the market. This strategy lets them profit from short-term market fluctuations.
Value Investing Metrics
Some value investors use the simple metric of a price-to-earnings ratio, focusing on companies with ratios below the market average or the average for that type of company. Another metric to look at is a company's underlying assets, targeting companies whose market capitalization is less than their asset values. Other value investors simply look at pricing, focusing on companies that have been punished by the market, assuming that the market's assumptions are overly pessimistic. One example of this strategy is to buy a defense contractor after its share price falls due to budget cuts, assuming that the budget cuts will eventually be reversed and the stock's price will return to its previous value.
The classic value investor -- Ben Graham -- defined stock screens that can help to identify potential value investment plans. One screen is that the company's share price should be less than two-thirds of the book value or net current assets per share for the company. Another is that its dividend yield should be more than two-thirds of what a AAA-rated corporate bond would yield. The screens also look for companies with some financial strength, indicated by having current assets that are at least two times the company's current liabilities as well as having a 10-year earnings growth rate of at least 7 percent.
Selling Value Shares
Famed value investor Warren Buffett has been quoted as saying that he thinks the best time to sell a block of shares in a company is never. However, given that a core part of value investing is to focus on stocks that are underpriced in the market relative to their actual worth, it's possible that those undervalued companies could some day end up being overvalued. Determining the exact point where the company's overvaluation has peaked is challenging. To this end, Francois Sicart of Tocqueville Asset Management recommends a slightly different rule of thumb -- that you should sell when you find an investment with more value potential than the investment you're currently holding.