Value Stock: What It Is, Examples, Pros and Cons

What Is a Value Stock?

A value stock refers to shares of a company that appears to trade at a lower price relative to its fundamentals, such as dividends, earnings, or sales, making it appealing to value investors.

A value stock can generally be contrasted with a growth stock.

Understanding Value Stocks

A value stock is a security trading at a lower price than what the company’s performance may otherwise indicate. Investors in value stocks attempt to capitalize on inefficiencies in the market, since the price of the underlying equity may not match the company’s performance.

Common characteristics of value stocks include high dividend yield, low price-to-book ratio (P/B ratio), and a low price-to-earnings ratio (P/E ratio). Investors can find value stocks using the "Dogs of the Dow" investing strategy by purchasing the 10 highest dividend-yielding stocks on the Dow Jones at the beginning of each year and adjusting the portfolio every year thereafter.

In contrast to value stocks, growth stocks are equities of companies with strong anticipated growth potential. A balanced, diversified portfolio will hold both value stock and growth stocks. Investment managers refer to these as a blend fund.

How to Determine and Invest in Value Stocks

A value stock will have a bargain price as investors see the company as unfavorable in the marketplace. A value stock will most likely come from a mature company with a stable dividend issuance that is temporarily experiencing adverse events. However, companies that have recently issued equities have high-value potential as many investors may be unaware of the entity. Investors can invest in these value stocks directly or by buying value exchange traded funds (ETFs) and value mutual funds.

There are several ways you can analyze a stock to determine whether it is undervalued. These methods include:

• Analyze the Price-to-Earnings Ratio (PE): This valuation tool compares the stock price to the earnings per share (EPS) of the company. A stock may be cheap and could be a value stock if its PE ratio is lower than that of its rivals in the same industry or the historical average.
• Analyze the Price-to-Book Ratio (PB): This metric contrasts the share price of a stock with its book value. A P/B ratio less than 1 indicates that the stock may be trading below its book value, which could be an indication of value.
• Check the Dividend Yield: A value stock may be indicated by a high dividend yield. A stock may be inexpensive and offer an alluring return in the form of dividends if its dividend yield is higher than the industry average or historic average.
• Evaluate Company Growth: This includes the company's historical and anticipated earnings growth. The stock may be viewed as undervalued and a potential value stock if its price does not correspond to the predicted earnings growths.
• Compare Against the Industry: Consider the stock's position within its industry and the general market environment while performing an industry and market analysis. A value stock may be identified if it is selling at a lower valuation than its competitors or the overall market.

Why Are Some Stocks Undervalued?

There's no single reason a stock is undervalued. In some cases, stocks may be undervalued as a result of investor mood and market dynamics. Stock prices may drop as a result of unfavorable news or pessimism about a certain industry, business, or market, potentially resulting in discounted possibilities. A firm may become undervalued as a result of poor financial performance, unfavorable earnings surprises, managerial problems, or legal challenges. For investors, temporary setbacks or market overreactions to bad news can present purchasing opportunities.

On the other hand, stocks may be undervalued based on more macroeconomic concerns. The state of the economy might affect stock valuations. Stock prices may drop during recessions or other uncertain times, undervaluing them in comparison to their intrinsic value. Stocks in sectors that are presently unpopular or going through a downturn can be undervalued.

Due to a lack of investor knowledge, stocks of smaller companies or those active in specialized markets may be undervalued. A company's stock may trade at a lower valuation compared to its genuine value if it is underfollowed or ignored by analysts and investors. Simply put, investors may overlook good stocks in turn for ones that are more popular or more commonly receive media attention.

Value Stocks vs. Growth Stocks

There's fundamental differences that distinguish value stocks from growth stocks.

Philosophy

The goal of value investing is to identify stocks that are cheap in comparison to their intrinsic value. Investors look for stocks that are trading for less than their intrinsic value. Meanwhile, growth investing focuses on stocks of businesses that have a potential for above-average growth in terms of profits, sales, or market share. Companies with significant growth potential, cutting-edge goods or services, and the potential to generate returns above average are given priority by growth investors.

Valuation

Traditional valuation indicators like PE ratios, PB ratios, or dividend yield are frequently used to identify value stocks. These measurements assist in identifying whether a stock is trading at a lower valuation than its fundamental indicators or its competitors in the same sector. Alternatively, growth stocks are frequently assessed using unconventional valuation techniques. This includes the price-to-sales (P/S) ratio or the forward PE ratio. Instead of reflecting current earnings or book value, these measurements show predictions for future growth.

Company Profile

Value stocks are frequently linked to solid, well-established businesses that operate in dependable sectors. Although their development rates may be slower, they are seen as financially reliable and may be undervalued by the market. Growth stocks are often found in sectors that have a strong potential for growth, such as emerging markets, healthcare, or technology. These businesses may have greater volatility because they are frequently in their early phases and reinvesting profits in growth.

Dividends

Value stocks frequently place a strong emphasis on dividend payments, and investors may look for shares in companies that offer high dividend yields. These equities are more common in mature industries, consumer staples, and utility sectors. This is because the company may not need as much capital for growth as the company has already scaled. Alternatively, rather than paying dividends, growth stocks frequently place a higher priority on reinvesting profits in the expansion of the business. These businesses frequently have to use their resources for marketing, R&D, or business expansion.

Risk

Value stocks are considered relatively less risky compared to growth stocks. They are typically more stable and have lower volatility. The potential for capital appreciation may be moderate, but they often offer steady income through dividends. In addition, the company is already established so may have already overcome many risks start-up or infant companies face. Meanwhile, growth stocks carry higher risk due to their higher volatility and market expectations. While they offer the potential for significant capital appreciation, they may also experience greater price fluctuations and have a higher chance of underperforming during market downturns.

Example of Value Stock

Honda Motor (HMC) produces and sells outboard engines, power generators, lawn mowers, and automobiles all over the world. Because the company has a less comprehensive vehicle lineup compared to rivals, it may fly under the radar with some investors. For instance, Honda does not offer a huge SUV or a full-sized truck. As a result, Honda is vulnerable to losing market share if consumer preferences move further in favor of those larger vehicles.

However, the manufacturer also possesses other traits that might be beneficial in the long run. One is that Honda has a reputation for quality, particularly with regard to fuel-efficient vehicles. The leadership group is skilled at organizing. The company's is currently embarking on a cost-cutting plan to decrease expenses. In addition, Honda aims to have 100% of their vehicles be electric in North America by 2040.

On the stock side, as of May 2023, Honda's stock had a P/E ratio of 8.57. This is notably less than rival companies such as Toyota, who boasts a P/E ratio as of May 5, 2023 of 10.14. Also, Honda boasts a stronger dividend yield. As of May 2023, Honda's dividend yield was 2.87%.

The Bottom Line

A value stock is a class of stock that the market perceives as being cheap in comparison to its intrinsic worth. Its price is lower compared to its fundamental metrics, such earnings, book value, or cash flow, and this is one of its defining characteristics. Value stocks are frequently linked to businesses with strong financials, consistent operations, and well-established market positions.