Value stocks are shares that look cheap compared with the company’s earnings, assets or dividends. Investors who buy them are betting that the market has been too pessimistic and that the price will eventually catch up with what the business is really worth. It is one of the oldest investment styles, and one of the most misunderstood.
What makes a share look cheap
Investors use a few common measures. The price-to-earnings ratio compares the share price with the company’s profits per share. A low number can suggest the shares are cheap. The price-to-book ratio compares the share price with the value of the company’s assets. A high dividend yield can also be a sign of value, because it means investors are paying relatively little for each pound of income.
Value shares are often found in sectors such as banks, energy, mining, insurance, utilities and industrial companies. The UK’s FTSE 100 has a reputation as a value-heavy index because it contains a lot of these businesses and relatively few fast-growing technology companies.
Value versus growth
The opposite style is growth investing, which focuses on companies whose sales and profits are expected to rise quickly, even if the shares look expensive today. Large technology companies are the classic growth stocks.
The two styles take turns in favour. Growth tends to do best when interest rates are low and falling, because the value of profits far in the future rises when they are discounted at a lower rate. Value tends to do better when rates and inflation are higher, and when the economy is recovering. Our guide to how growth and value rotate when yields rise explains the mechanics.
You could see a version of that last week. As technology shares were sold and oil climbed, money moved towards energy and other parts of the market that had been left behind. Our Morning Market Brief has the latest moves.
The value trap
The biggest risk with value investing is the value trap. A share can look cheap because something is genuinely wrong with the business. Profits may be about to fall, debt may be too high, or the industry may be in long-term decline. In that case the share can keep getting cheaper for years.
To avoid that trap, look beyond the headline ratio. Ask whether earnings are stable or falling, whether the company has a strong balance sheet, whether the dividend is covered by cash flow and whether there is a reason the market might change its mind. A cheap share with no catalyst can stay cheap for a long time.
How beginners can use the idea
Value is a useful lens rather than a strategy on its own. It helps you ask whether you are paying a sensible price for what you get. Combine it with an understanding of the business and the economic backdrop, and keep position sizes sensible, because value shares can stay out of favour for longer than you expect.
The bottom line
Value stocks are shares priced cheaply relative to their fundamentals. They can reward patient investors when sentiment turns, but cheapness alone is not a reason to buy, so always check why a share is cheap before deciding it is a bargain.
If you want to find out how you handle decisions like this, and where your own trading could improve, the free Samuel & Co Trading Trader Assessment is a sensible next step.
