Even today, deep value investing continues to be a popular method for investors around the globe. Many have claimed that this method really works and, one way or another, has been a part of investors’ success.
Do you want to learn how to be successful with deep value investing and determine whether it’s something you want to join in? Rather than go through tons of deep value investing books, get a brief yet comprehensive guide in this article.
Deep Value Investing Definition
Deep value investing is an investment strategy that emphasizes selecting stocks that are cheap but offer excellent value. Generally, investors will park their money in stocks that they think will soar high in the future, based on the company performing well. However, with deep value investing, you focus on recognizing undervalued stocks and those with assurance between value and price, which act as a sort of “safety net.”
While most investors are concerned about future prices, deep value investors are more interested in finding which stocks are priced lower than the value they offer. Let’s take a close look at what characteristics make a stock appealing to deep value investors.
How to identify which investments have deep value?
It may sound simple but investing in deep value stocks isn’t easy. You need to use statistics in the form of valuation multiples to compare two similar companies and conclude whether the company being examined is trading below its net current asset value (NCAV).
NCAV is the total worth of a company’s assets minus any liabilities. So if a company is trading below NCAV, this means when you buy its stock, the face value of its assets is now worth more than the price you’ve paid for. So, even if the company will liquidate its assets on the same day you bought stock, you will still appear on top.
One crucial element of deep value investing is valuation multiples. This allows you to compare companies objectively to other metrics often used by investors.
During the course of British economist Benjamin Graham’s research, he focused on a stock’s intrinsic value and learned that lower valuation multiples tend to beat out the market’s performance and yield high returns. There are different valuation multiples to see how companies compete against one another and find which stock offers a higher value.
How to Calculate
The goal of deep value investing is to calculate what percent of the company’s asset value and price of the stock is trading at. There are many ways to calculate a valuation multiple, which all serve to measure the stock value by dividing its estimated value by a particular number on the company’s financial statements.
The commonly used calculations are:
Price-to-Earnings (P/E) ratio or P/E ratio
To calculate, divide the current stock price or market value per share by the earnings per share. Calculate earnings per share (EPS) by dividing the company’s profit by the number of outstanding shares of its common stock. EPS is the total sum of money that a company will pay to its shareholders per share if it gives all its profits. Investors go for higher EPS as it indicates a company’s profitability and strength.
Since you’ll want a higher EPS but a lower price, a low P/E ratio is a good indicator that a company is undervalued. This often helps deep value investors to determine which value stocks to purchase quickly.
Price-to-Book (P/B) Ratio
Like the P/E ratio, the P/B ratio starts with the market price per share as a numerator. The denominator is the book value per share (BVPS), which is then calculated by dividing the stockholder’s equities (assets minus the liabilities) by the number of common shares. Deep value investors also look for a low P/B ratio as a sign that a stock is undervalued.
Risks of Deep Value Investing
Any investment, regardless of the value, is subject to risks. Whether you invest in bonds, commodities, or stocks, there’s always a possibility of losing money.
In the same way, deep value investing is no different. Although it comes with its own risks, they tend to be less as a whole compared to other popular investment strategies.
Below you’ll find the risks you may have to acknowledge.
The reality is every time you get a good deal on a stock price, you’re just taking a chance. And since deep value usually disregards a strong company’s apparent qualities, such as good leadership and a unique business model, there’s a good chance that you’re investing in a mediocre company that is still struggling.
It’s hard to predict the future, which means buying cheap stocks can lead to erratic price swings. Deep value stocks may go up and down, so expect a roller coaster ride of price fluctuation.
Another risk concerning a deep value investor is the error in calculations. You may already identify deep value stocks, and they may perform well, but it doesn’t matter if you don’t buy them.
As a deep value investor, you have to ensure that your calculations are accurate. Always double or triple check the numbers for accuracy before buying the stock.
Most people who are unfamiliar with the stock market are attracted to brand-names like blue-chip companies, which are proven “powerhouses”. Because these are big companies that are also well-known, the chances of getting a good and cheap price on their stock are low.
Nevertheless, people will still buy their stocks because they seem to be a safe-haven. Many deep value stocks pose the risk of investing in a company that is well-known, but doesn’t have a rich history, lacks management and models of the blue-chips, and is often struggling. Simply put, deep-value investing may entail you to invest in a company that is not very good.
Diversify and Exercise Patience
You may have heard about the saying “don’t put all your eggs in one basket,” the same principle applies to deep value investing. To minimize risk exposure, make sure to diversify your investment portfolio. This way, even if one industry undergoes a seismic shift, you can weather the storm and still come out on top through the success of your other investments across different sectors.
Finally, remember that deep value investing isn’t something that you can get rich quick. It requires time and, most of all, patience. Often, the reason you can buy a company’s stock at a low price below its actual value is that it’s struggling. Be patient and give the company enough time to bounce back so that you can reap good benefits.
To read more on topics like this, check out the Business category
Leave a Reply