What is value investing: Valuing investments 101

What is value investing?

In our valuation driven investing 101 guide, discover how you can recognise stocks that are undervalued and bring financial calculations to life.

The concept behind valuation-driven investing is simple. Identify stocks whose true potential isn’t reflected in the current share price and hold on to them until the broader market recognises what they’re worth.

These are normally companies with great long-term potential, that are undergoing change or have strong growth perspectives, but are presently unloved.

Calculating investment opportunities

This guide takes a look at the financial metrics and ratios used to determine if a company’s valuation makes a good investment. 

Step-by-step we break down how to calculate price-to-earnings ratios (P/E ratio), price-to-book ratios (P/B ratios), return-on-equity (ROE), discounted cash flows (DCF) and dividend yields. We provide you with the formulas so you can calculate them yourself.

By using fictitious companies as examples, you will learn how to interpret these financial metrics. Discover which of our apple tree firms has a good P/E ratio or find out what real estate company has a better P/B ratio.   

Value investing strategies

We use these calculations to determine a stock's value in both the active and the passive space.

In our RAFI ETF range, fundamental measures such as sales, cash flow, dividends and book value are used to determine a stock’s index weight. The range uses methodology developed by Research Affiliates that assigns weights based on the economic size of a company. So, ETFs are weighted by fundamental value, as opposed to market cap.

On the active side, price-to-earnings ratios, price-to-book ratios, return-on-equity and discounted cash flows are used to identify stocks on low valuations.

Our guide teaches you the opportunities and limitations of how you can use them.

If you are looking for a calculation that provides a good representation of long-term earnings trends, then the P/E ratio works well. While other ratios like the P/B are suited to capital intensive firms such as manufacturers rather than companies that hold intangible assets like software.  

Risks with value investing

Valuation-driven investing is not without caveats and results need to be taken into context of the company and the sector.  To get the best investment results they should not be used just in isolation, instead a thorough stock analysis understanding using various metrics is needed.

For example, a higher P/E ratio could mean a company is overvalued or investors are expecting high growth rates in the future. While a lower P/E could mean a company is undervalued or investors think it has limited growth potential.

Similarly, a lower P/B ratio generally means a company is better value, but it can also signal a company is in trouble.

For ROE, the metric should be only used to compare companies within the same industry, not across different sectors.

A DCF is based on future cash flows and relies on various factors and there can be unforeseen threats or opportunities. If an investor cannot access the future cash flows, the DCF will not have much value.

When it comes to dividend yields, a high dividend yield does not always mean it’s the best stock to invest in, especially if the stock price has recently plummeted.

There are lots of factors to consider, through our guide you can understand what makes a good investment and bring financial calculations to life.

Learning objectives

In this guide, you’ll learn:

1. How we identify companies whose valuations have not yet been reflected by the market.
2. How we calculate financial ratios like price-to-earnings ratios, price-to-book ratios, return-on-equity and discounted cash flows.
3. How we interpret the numbers and bring financial calculations to life.

Our guide is also accredited for 45 minutes of structured CPD, just take our online test at the end.