But why does the market undervalue the stocks in the first place? There could be many reasons for this. The market may at times over-react to some adverse news about the company or the specific industry in which the company operates or lower than expected financial results of the company and beat down the stock to such an extent that the low price may be out of sync with the long-term fundamentals of the company. The low price does not reflect the true value of the stock, it presents an opportunity for the value investor to purchase the stock at a value that is much lower than its intrinsic value.
But how does one determine the intrinsic value of a stock? This is a bit tricky, because different investors may have different estimates of the intrinsic value of a stock, depending on the methodology used for estimation of the value. While some investors may use the current assets to current earnings ratio without taking into account the projected growth of the company, others may consider the future growth estimates and cash flows to arrive at the intrinsic value of the stock. Despite this difference in methodologies, the ultimate test is the ability of the investor to buy the stock at a price lower than its actual worth.
Value investing seeks to exploit the irrational price movement of a stock on account of emotional reaction of the markets to specific news about the company or the industry. The irrational behaviour may be due to fear or greed of marketmen and these emotions play an important role in driving price movement in the markets on a daily basis.