Value investing is a style of investing based on picking shares that have low valuations relative to their current profits, cash flows and dividend yield. It is one of the two main approaches to stock picking, the other being growth investing.
Value investing is generally regarded as lower risk than growth investing. Unlike growth investing, which is only suitable for investors looking far capital gains, value investing strategies can be used by investors looking for either capital gains or income — although an income investor is likely to use a different value strategy to one who wants capital gains.
Value investors look for low valuations on current earnings rather than for higher valuations that may be justified by future growth. A value investor is more likely than a growth investor to prefer a share with a low valuation and stable earnings to one that has a higher valuation and growing earnings.
Value investing is less likely than growth investing to interest investors who are looking for dramatic results in the short term, however there are a number of value investors who have been very successful.
There is strong evidence that value shares outperform growth shares over the long term. This is called the value effect.
Exactly what measures a value investor will look at varies. PE and dividend yield are obviously easy and are widely used but EV/EBITDA is also useful and the most successful value investors seem to pay a lot of attention to cash flows. The last is, after all, theoretically the most correct approach.
Investors who emphasise yield should also look at earnings and cashflows, if only to ensure sufficient dividend cover.
There is usually a reason for low valuations. This can lead investors into value traps. Investors should know why a stock is cheap before buying it. For example, if the historical or prospective PE (or yield, price/cashflow etc.) is very low, there may be a risk of a significant deterioration.