Value investing refers to buying stocks that have a low price relative to various metrics (i.e. dividends, earnings, sales, etc.). It does not mean buying cheap stocks – value investing means analyzing stocks to find out which ones are being offered at a value price. Value investing tends to highlight stocks that are out of favor and therefore overlooked. A common method of value investing involves examining the price to earnings ratio (i.e. PE ratio). A relatively low PE ratio is an indicator of value – the stock is being offered at a low price compared to the earnings reported. Look at the following example:
Company A has a share price of $56 earnings of $7 per and a resulting PE ratio of 8.
Company B has a share price of $48 earnings of $5 per and a resulting PE ratio of 9.6.
If everything else is equal, buying shares of Company A is the value option. Even though the price per share is higher, the investor is only paying 8 times earnings whereas investing in Company B requires and investment of 9.6 times earnings. The price of a stock may be undervalued in the market place because the company or industry may have fallen out of favor while companies that are considered part of the latest or hottest trend have a premium placed on their stock price over and above the industry average.
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