Investing in ASX value shares

What are ASX value shares?

Value stocks are companies perceived to be trading at bargain prices. Perhaps they have been unfairly punished by the market because of some recent negative publicity, or they operate in a less popular sector of the economy.

Whatever the reason, value shares possess more robust fundamentals than their current share prices would otherwise indicate. In other words, these shares are trading on the stock market for less than their intrinsic value.

Value investors seek to capitalise on these discounted stocks by first identifying value shares in the market now, typically by looking at some key financial metrics.

They then buy these shares, hoping their prices will eventually increase to a level more aligned with their actual underlying business performance.

Top value stocks on the ASX

Identifying value shares can be subjective. After all, what seems like a bargain to one investor may seem like a bona fide dud to another. With that caveat out of the way, here are three major ASX shares that could offer good value to investors right now, rated by market capitalisation from high to low.

Woolworths

Woolworths operates Australia’s largest chain of supermarkets and grocery stores. For the 52 weeks ended 26 June 2022, Woolworths generated more than $60.8 billion in revenue and $1.5 billion in net profit. These are some hefty numbers, even if ongoing supply chain issues still mean lower profits than prior to the pandemic.

However, as economies worldwide shrug off most of their COVID-19 restrictions, many of these supply chain issues may resolve. And while inflationary pressures on costs remain a risk, supermarkets are often good defensive shares to hold during an economic downturn, as demand for food and pantry staples is relatively inelastic.

Treasury Wine Estates

Shares in Treasury Wine Estates collapsed in 2020 after the Chinese Government announced it was hitting its Australian wine imports with a whopping 169% tariff – and the wine industry hasn’t fully recovered since. Treasury Wine Estates used to sell about $500 million worth of wine to China each year, and the tariffs dealt a devastating blow to the company when COVID-19 lockdowns were also limiting wine sales to hospitality venues.

However, excluding mainland China, net sales revenue for the year ended 30 June 2022 increased by 9%, and the company is continuing to explore growth opportunities elsewhere in Asia. It is also growing its presence in the United States through its Treasury Americas division, targeting the premium end of the wine market.   

Challenger

Challenger is an investment management company that specialises in annuities. When you buy an annuity, you pay a large sum of money upfront in exchange for a regular income stream over the investment term. In the case of a lifetime annuity, the term is the rest of your life. These products cater mainly to retirees who want to ensure they have a steady income throughout their retirement.

Challenger benefits from rising interest rates because it invests its capital into fixed-income investments. It then uses the interest from these investments to make regular payments to customers. As rates rise, the return Challenger earns on new investments increases, and so should its profit margins.

What to look for when investing in value shares

Value investors essentially believe in the principle that the market tends to overreact to good or bad news.

They think investors often get overexcited by a piece of good news about a company and bid up its share price to excessively high levels. But they equally believe that if shareholders see a negative story in the media about a company they own, they tend to panic unnecessarily and sell their shares before taking the time to properly consider whether it is the best long-term decision to make.

This herd behaviour can result in shares falling to bargain prices, allowing other investors to profit by picking them up for less than their intrinsic worth.

Value investors try to identify shares that have been oversold by focusing on key valuation metrics. These often include (but are not limited to):

• Price-to-earnings (P/E) ratio
• Price-to-book (P/B) ratio
• Debt-to-equity ratio. 

Price-to-earnings (P/E) ratio 

This is a commonly-used financial metric that shows how much an investor has to pay per dollar of return on their investment. The P/E ratio is calculated by dividing a company’s share price by its earnings per share (EPS).

A company’s earnings (or net profits) represent shareholder returns. It is the excess cash a company can use to either pay dividends (which means income to shareholders) or reinvest into growing the company (which should eventually translate into a higher share price and a future capital gain for shareholders).

A high P/E ratio shows investors are willing to pay a lot per dollar of incremental return. While this might be a sign that a company is overvalued, it can also indicate that investors are willing to pay a premium now with the expectation that the company will grow earnings significantly in the future. A low P/E ratio, on the other hand, may indicate that a company is trading at a bargain.

The average P/E ratio for the Australian market tends to be around 15,¹ although this can change over time depending on business conditions and the economic outlook. So a share with a P/E ratio below 15 may be considered relatively undervalued, while a share with a ratio above 15 may be considered relatively overvalued or expensive.  

However, it’s important to point out that, on its own, a share’s P/E ratio doesn’t tell you too much about whether the stock offers good value. 

P/E ratios can be a good measure of relative value when compared against other shares in the same or similar market sectors. A share with a P/E ratio that seems low may actually be high relative to its competitors – meaning the share may not offer good value after all.

Price-to-book (P/B) ratio 

A stock’s P/B ratio is calculated by dividing its price by the company’s book value per share. Book value, or net value, is a company’s assets less its liabilities, and measures how much a company is worth.

A share’s P/B ratio shows how much investors are willing to pay for a dollar of the company’s net assets. A P/B ratio of about one indicates a share is fairly priced – investors pay a dollar per dollar of net assets. A ratio of less than 0.5 might indicate a bargain to value investors, as it shows that the company’s shares are trading for less than half their book value.

Debt-to-equity ratio

When a company wants to finance its operations, it can either take out some form of loan (by borrowing money or selling bonds) or raise money by issuing new shares (also called equity). A company’s debt-to-equity ratio measures how much of its financing it raises through debt relative to equity.

A debt-to-equity ratio below one is typically considered safe. If a company finds itself in dire straits, it could sell some of its assets to cover its debts and possibly still survive.

On the other hand, a debt-to-equity ratio of two or above is getting into more risky territory. If the company suffered some sort of crisis, it might find it much more difficult to meet its debt obligations.

A high debt-to-equity can be risky for shareholders because it may indicate that a company has an unsustainably high level of debt. This can pose a problem because a company needs to earn enough money to meet its interest obligations. Otherwise, it risks defaulting on its loan repayments and could even go bankrupt.

However, on its own, a high debt-to-equity ratio isn’t necessarily bad, and it needs to be understood in the context of the broader industry in which the company operates. For example, some sectors – like the airline industry – generally tend to be highly leveraged, so their debt-to-equity ratios are likely to be relatively high.

Difference between ASX growth and value shares

Although investors buy both growth and value stocks in the hope they will profit from a future price gain, they are motivated by very different factors.

A growth stock is typically a junior company that may not yet be turning a profit. Investors buy them based on their perception of each company’s market opportunities and future earnings potential. As such, growth stocks tend to be riskier investments than value stocks, although the potential return for investors may be much greater.

A value stock is more likely to be an established company that has been oversold by the market and is now trading at a lower price than its underlying fundamentals would suggest it is worth. A value investor will buy the undervalued stock in the hope that its price will soon revert to a level more in line with its intrinsic value. 

Because it is more likely to be a mature company, a value stock is typically a lower risk than a growth stock – but this also means that the potential shareholder returns on offer are probably lower.

Pros of investing in value shares

Who doesn’t love a bargain? Investing in value shares means following the simple strategy popularised by Warren Buffett: buy low and sell high.

Lower risk: Value investors typically target more mature companies with a proven track record, so it is lower risk (and less speculative) than growth investing. This might suit investors with a lower risk appetite but who are still looking to grow the value of their wealth over the longer term.

And the cons

Time-consuming research: To identify a value stock, you need to have a good general understanding of the stock market and intimate knowledge of the company’s financials. This may require many hours of research and careful monitoring of market price fluctuations. Not every investor has the spare time available to pursue such a strategy.

Lower share price growth: Value investors often seek to profit from smaller movements in share prices than growth investors. This might mean the gains generated from a value investing strategy may not be enough to justify the time spent on it – particularly for investors who only have smaller amounts of money available to invest in the stock market.

Are ASX value shares right for you?

Value investing requires a fair amount of research and industry knowledge. It’s not always easy to identify which ASX shares are bargains and which are genuine duds – which often makes value investing a subjective exercise. You’re not always going to get it right. What you think might be a temporary drop in a company’s share price could be the beginning of a significant crash.

Therefore, before investing in a company, always ensure you have a firm grasp of its financials and understand the key factors affecting its industry. And, most importantly, make sure you can explain why you think the market currently undervalues it. If you can’t do that, then it’s just pure speculation!