Value stocks: how they work and key metrics for trading

As any experienced bargain hunter will attest, there's cheap and there's good value. Some things are cheap for a reason. Plenty of stocks will be cheap, but that's not what gets a value investor excited. The best value stocks for 2021 are those where the market has fundamentally misunderstood their growth prospects. So, what are value stocks and what should investors be looking for?

High value stocks can be relative

In uncovering value stocks, investors will look both at whether a stock is cheap relative to its intrinsic value, but also whether it has prospects for recovery. The premise of value investing is that good quality stocks occasionally become unfashionable, and if you can buy them at a lower price, you can make money. This is very different to buying bad companies at a low price and hoping they may become less awful.

A range of factors can mean companies are undervalued

It may be as simple as investors misjudging the growth prospects for a company. If a company is valued as if it will grow at 5% and it looks set to grow at 20%, it will be undervalued. As such, while many people think of value stocks as low growth, this isn’t necessarily the case.

Sectors become unfashionable. When everyone is looking at technology or green energy, they may not be paying attention to, say, media or financials even though there could be great businesses in those sectors. The same may be true for countries. A technology company in the US may garner lots of attention, but a similar company in the UK may not come onto the radar.

It may also be that a company has short-term problems that the market over-interprets. For example, supply chain concerns can cause short-term damage to profitability, but may be quickly resolved. The share price may drop as investors lose their nerve. This can be an opportunity for the value investor.

There may also be cyclical fluctuations in a company’s performance. Certain companies tend to do particularly well in a buoyant economic climate, but it can leave them neglected during difficult periods. Investors can assume that a cyclical downturn is structural and the share price may fall below a company’s intrinsic value.

Various metrics help to determine a company’s relative value

These will generally work in combination, rather than as single metrics:

• Price-to-earnings ratio (P/E) – a company’s share price, divided by its earnings. A low P/E ratio can suggest a company is lowly valued, but the ratio doesn’t measure whether a company is growing its earnings or whether it has had a temporary blip.
• Price-earnings to growth ratio (PEG) – the same as the P/E ratio but brings in a measure of how fast earnings are growing.
• Debt-equity ratio (D/E) – compares a company’s total debt to its shareholder equity. Higher ratios tend to indicate a company with higher debt, which would usually be judged as higher risk investments.
• Return on equity (ROE) – a measure of how much money a company makes on its investments. A high ROE ratio shows whether it is investing wisely or whether it is deploying its cash sensibly.
• Dividend yield – a company’s dividend payout relative to its share price. In general, a high yield can indicate a ‘cheap’ company but can also show that the market expects the dividend to be cut.
• Price-to-book ratio (P/B) – a measure of a company’s share price relative to its assets. It is calculated by dividing the company's stock price per share by its book value per share. Book value is usually asset value less its liabilities.

It doesn’t have to be value versus growth stocks

Value and growth are equally valid approaches to selecting stocks. Growth focuses on how fast a company is growing, while value focuses on the price paid. In reality, they are two sides of the same coin. Value investors still want to find businesses with long-term growth prospects, while growth investors don’t want to over-pay.

Ways to invest in value stocks

Value stocks can be found in any sector, depending on the market environment. Many investors will want to compile their own value stock list – perhaps by looking in unfashionable sectors such as retail, leisure or others hard-hit by Covid. Another option is to look at some of the companies that appear in the key ‘value’ indices: the S&P 500 Pure Value Index, MSCI World Value Weighted Index and Russell 3000 Value Index. It is also possible to find ETFs based on these indices, which can give diversified exposure to value stocks.

The alternative is to find a good active manager. Jupiter is just one example with a well-respected value team; its Jupiter Income Trust is a potential option for those who believe in the value approach.

The Fineco trading platform offers a range of options for potential bond investors, with all the tools you need and clear, fair lets you trade across a broad range of markets, indices and currencies, all from a single account with clear fair pricing.