Value investors want to buy stocks for less than they're worth. This concept certainly makes sense -- after all, if you could buy $100 bills for $80, wouldn't you do so as often as possible? Of course, this is easier said than done. Here's an overview of what value stocks are, examples of some excellent beginner-friendly value stocks, and some key concepts and metrics that value investors should know.
What are value stocks?
Value stocks are publicly traded companies trading for relatively cheap valuations relative to their earnings and long-term growth potential.
Here's one important concept for all investors to understand. Most stocks are generally classified as either value stocks or growth stocks. Generally speaking, stocks that trade for valuations below that of the average stock in the S&P 500 are considered value stocks, while stocks with above-average growth rates are considered growth stocks. Some stocks have both attributes, or fit in with average valuations or growth rates, so whether to call them value stocks depends on how many characteristics of such stocks they have.
Value stocks generally have some common characteristics. They typically are mature businesses, have steady (but not spectacular) growth rates, and have relatively stable revenues and earnings. Most value stocks pay dividends, although this isn't a set-in-stone rule.
Some stocks clearly fit into one category or the other. For example, 130-year-old spice manufacturer McCormick (NYSE:MKC) is clearly a value stock, while fast-moving Tesla (NASDAQ:TSLA) is an obvious example of a growth stock. On the other hand, some stocks can fit into either category. For example, there's a case to be made either way for tech giants Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT).
However, that a stock is classified by someone as a value stock doesn't necessarily mean it's a good value right now. That's where your analysis must come in. Let's take a look at three excellent value stocks -- Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), Procter & Gamble (NYSE:PG), and Johnson & Johnson (NYSE:JNJ). Later on, we'll dive into some of the metrics that can help you find the best ones to invest in.
If you could buy $100 bills for $80, wouldn't you do so as often as possible?
3 excellent value stocks for beginners
- Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B): Since CEO Warren Buffett took over in 1964, Berkshire Hathaway has snowballed into a conglomerate of more than 60 wholly owned businesses and a massive stock portfolio with more than four dozen different positions. Berkshire has steadily increased its book value and earnings power over time -- and currently still operates under the same business model that has led the stock to more than double the annualized return of the S&P 500 for over 55 years.
- Procter & Gamble (NYSE:PG): Consumer products manufacturer Procter & Gamble owns some of the most recognizable brands in its various industries. It is the company behind brands such as Gillette, Tide, Downy, Crest, Febreze, and Bounty, but there are dozens more in its product portfolio. Through the success of its many brands, Procter & Gamble has been able to increase its revenue steadily over time and has become one of the most reliable dividend stocks in the market, increasing its payout annually for more than 60 consecutive years.
- Johnson & Johnson (NYSE:JNJ): The healthcare giant is best known for its consumer healthcare products, such as the Band-Aid, Tylenol, Neutrogena, Listerine, and Benadryl brand names, just to name a few. But the majority of its revenue comes from its pharmaceutical and medical device businesses. Healthcare is one of the most recession-resistant businesses in the economy, and Johnson & Johnson has produced steady revenue (and dividend) growth over time.
One important thing for investors to understand is the difference between a value stock and a value investor. A value stock is a company to which traditional methods of fundamental analysis can be applied. A value investor, on the other hand, refers to someone with a primary investing goal of identifying good companies trading for a discount to their intrinsic value.
Long-term investors can generally be classified into one of three groups. Value investors try to find stocks trading for less than their intrinsic value by applying fundamental analysis. Growth investors try to find stocks with the best long-term growth potential relative to their current valuations. And investors who take a blended approach do a little of each.
There have been several famous value investors. Warren Buffett, the CEO of Berkshire Hathaway, is perhaps the best-known value investor of all time and has a proven track record of investing in stocks and even entire companies at significantly less than their intrinsic value. The proof is in the performance: From the time that Buffett took control of Berkshire in 1964 to the end of 2019, the S&P 500 has generated a total return of 19,784%. Berkshire's total return during the same period has been a staggering 2,744,062%. That's not a typo.
Although he isn't as well known as Buffett, Benjamin Graham is often referred to as the father of modern value investing. His books The Intelligent Investor and Securities Analysis are must-reads for serious value investors, and Graham was actually Warren Buffett's mentor.
How to find value stocks to invest in
The point of value investing is to find companies trading at a discount to their intrinsic value, with the idea that they'll be likely to outperform the overall stock market over time. Unfortunately, finding stocks that trade for less than they are truly worth is easier said than done. After all, if it were easy to buy $1.00 for $0.80 over and over, everyone would be rich.
That said, here are three of the best metrics to keep in your toolkit as you search for hidden bargains:
- P/E ratio: This is the best-known stock-valuation metric, and for a good reason. The price-to-earnings or P/E ratio can be a very useful tool for comparing valuations of companies in the same industry. To calculate it, simply divide a company's stock price by its last 12 months of earnings.
- PEG ratio: This is similar to the P/E ratio but adjusts to level the playing field between companies that might be growing at slightly different rates. (Thus PEG, or price-to-earnings-to-growth, ratio.) By dividing a company's P/E ratio by its annualized earnings growth rate, you get a more apples-to-apples comparison between different businesses.
- Price-to-book (P/B) ratio: Think of the book value as what would theoretically be left if a company ceased operations and sold all its assets. Calculating a company's share price as a multiple of its book value can help identify undervalued opportunities, and many value investors specifically look for opportunities to buy stocks trading for less than their book value.
Don't underestimate the power of value stocks
While they might not be quite as thrilling as their growth stock counterparts, it's important to realize that value stocks can have just as much long-term potential as growth stocks, if not more. After all, a $1,000 investment in Berkshire Hathaway in 1964 would be worth more than $27 million today. Finding companies that trade for less than they are truly worth is a time-tested investment style that can pay off tremendously well.