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What is value investing?

Value investing means investing in stocks that are currently trading for less than their book, or intrinsic, values. The term can be applied to any other investment that sells in the market for less than its book value.

Value investors use strategies

In general, they seek reasons that a stock's potential may have been overlooked and that its actual trading price may soon increase.

For instance, a stock may be undervalued because its short-term outlooks are poor. Maybe it is in a depressed industry, or perhaps sudden growth in a new market has temporarily decreased earnings. Management may be overly conservative and may not promote the company as much as it deserves.

A variety of reasons may contribute to the stock's undervaluation. If these problems appear temporary, a value investor may decide that the stock is undervalued. But is now the best time to purchase this stock? What is the likelihood that the stock price will increase in the near future?

Value investors aim to identify variables that may soon push up the price of a stock: new management, a revised stock analysis by Wall Street, or a corporate takeover, for example. These variables may relate to the internal operation of the company, such as new management or a new product introduction. Or, they may be external variables, such as a revised stock analysis, falling interest rates, or an upturn in the industry.

What to look for in value investing: P/B and P/E ratios

Many factors can help investors identify strong companies with stock that is temporarily undervalued.

A starting point may be to look at the price-to-book ratio (P/B) and the price-to-earnings ratio (P/E). The price-to-book ratio is the stock price divided by the book value (the value of the company's assets). If a stock's price is $20 and its book value is $30, the price-to-book ratio is 2/3.

A stock with a price-to-book ratio of 2/3 or less may indicate a value stock. Similarly, the price-to-earnings ratio is the stock price divided by the company's annual earnings. A stock with a price-to-earnings ratio of 2/3 or less that of other companies in its respective industry or the market as a whole may also be a value stock.

Return on equity

Another important factor to review is the company's return on equity (ROE). The ROE is a percentage calculated by dividing the net income of a period by the common stock equity, or net worth.

When it comes to value investing, a declining ROE can be a good thing, since it may suggest that the company is financing with less debt and holding more assets, which could be used for acquisitions or other growth. Of course, further investigation would be necessary to confirm those reasons.

Value investors also may examine a company's dividend yield, or the investor's annual percentage of return per share, as well as its debt load, cash flow, assets, and earnings history. Identifying these figures can help investors evaluate whether the company has the resources and expertise needed to grow profits and deliver earnings in the future.

Dive Deeper: Investment strategies 101: The full breakdown

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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