When it comes to investing, you may have heard the term value stock before. Perhaps it made you curious. “What is a value stock?” you’ve wondered.

There’s a sense in which it is precisely what it sounds like: It’s a stock that provides good value to the investor – or at least has the potential to. But how?

In this article, we’ll do the following:

• Define what a value stock is
• Differentiate them from growth stocks
• Provide some examples
• Show you how to pick particular stocks.

Value Stock Definition

A value stock is a stock whose price is lower than its intrinsic value, where intrinsic value is determined by measures such as a firm’s revenues, earnings per share (EPS), dividend payouts or other underlying factors.

 

So, let’s say PepsiCo stock is currently trading at a market price of $170 per share.

But after analyzing PepsiCo’s fundamentals, you determine that the price really should be more like $200.

You’ve now identified a value stock, and you should invest in it to take advantage of the market inefficiency. After all, if you are correct about its true valuation, eventually the rest of the market will catch on to its real value.

This makes you a contrarian investor because you are looking for the opportunities that go against the grain of common wisdom. Everyone else thinks the stock should sell at $170, but you see that its true value is higher.

Other value traders might buy the stock as well. That is, until its price is pushed all the way up to or beyond $200.

At that point, the market will have corrected for the bargain price of the stock and its current value will be equivalent to its intrinsic value.

This is a great way to make money in the stock market. But it’s not the only way. So, let’s take a look at the difference between growth and value stocks.

What Is the Difference Between Growth and Value?

The difference between a growth and a value stock is that with growth stocks, rather than looking for bargains, investors are betting on fast-growing companies. They hope the stocks will continue to grow at a rate outpacing the market average.

Growth investors have the opportunity to make a lot of money as the price of the stock goes up. As the company continues its rapid growth, so should its share price, goes the theory.

At the same time, a growth company will often reinvest much of its profits back into capital and research investments, helping to spur on its growth even further.

Examples of growth stocks in today’s markets include Adobe, Salesforce.com and Expedia.

Which kind of stock is better to invest in: growth or value? Well, that’s up to the individual investor to determine. You can make a lot of money playing either type of equity strategy.

Of course, sometimes diversifying your portfolio to include both types is the best overall play so that you can spread your risk around.

What Are Some Examples?

When people think about value stocks, they tend to think of companies in relatively mature industries. For example, financial companies like Bank of America and Wells Fargo and energy companies like BP and Exxon will often be treated as such.

Mature companies – like PepsiCo and its competitor Coca-Cola – will often pay stable dividends. The stability of their dividends helps to drive the perceived value of the stock.

But adverse events can sometimes cause the prices of these mature companies to take a hit. For example, maybe Exxon’s quarterly earnings per share came in low or it had a bad public relations gaff on social media.

This may temporarily drive the price of the stock lower than it really should be. And this creates the kind of buying opportunity a value investor should be seeking.

How Do You Choose an Undervalued Stock?

Now that we’ve learned how to spot potentially undervalued stocks, how can we figure out whether a particular value stock is a good buy?

There are a number of measures and financial ratios you can use to calculate the intrinsic value of the stock. Once you’ve arrived at a stock’s intrinsic value and you’ve determined that the stock is trading lower than it should be, that stock is now ripe for the picking.

A common way to measure the intrinsic value of a stock is to look at either its P/E ratio (price-to-earnings ratio) or its P/B ratio (price-to-book ratio).

Take the P/E ratio. Let’s say Exxon’s stock is trading at $75 and the annual EPS of the company is $5. That means that the P/E ratio is 15, as 15 x $5 = $75.

But let’s say the average P/E ratio for similar energy companies is actually 17, and that their average EPS is also $5. Those stocks would be trading around $85.

The value investor, believing that Exxon is a fundamentally sound and healthy firm, expects to see its price correct to the $85 industry average price and will therefore invest.

Other indicators an investor may look at to determine a stock’s deviation from its intrinsic value include…

• PEG ratio (price-to-earnings to growth ratio)
• Dividend yield
• Current cash flows
• Current liabilities.

Are Value Stocks Right for Your Portfolio?

Whether or not value investing is the best strategy for you is an individual decision. Every investor must decide for themselves. But there’s definitely a lot of money to be made by utilizing a value trading strategy. Though every investment strategy comes with risk, the potential rewards available to you are really unlimited.

Now that you have a better understanding of what a value stock is, it’s time to take the next step and see if value investing could be part of your journey to financial health and wealth.