While value investing can be highly profitable, it’s rarely easy.
For starters, it can be pretty difficult to accurately determine the true intrinsic value of a firm. These calculations always involve unknown variables and assumptions about the future. What’s more, uncovering mispriced stocks can be a time-consuming and research-intensive task. Even when a value investor is spot-on with his assumptions, it may take a while for the rest of the market to reach the same conclusion. In other words, undervalued stocks can remain that way for a long time before other investors finally catch on.
Still, all of this work can be well worth the effort. Yet, if you ask most people to explain their process for finding “good values,” they’ll likely mention P/E ratios. The discussion largely ends there. While this widely used ratio provides an essential measure of a company’s stock price to its earnings, there is much more to value investing.
4 Ways To Find Value In The Stock Market
While no single metric will allow investors to uncover the best value plays, our research staff considers several factors when looking for strong candidates. Below, we’ll discuss just a few of our favorites…
1. P/E-To-Growth Ratio (PEG)
One of the major shortfalls of pure P/E comparisons is that it doesn’t account for growth. That’s where PEG ratios come into play.
PEG ratios are calculated by dividing a company’s P/E by the firm’s long-term estimated annual growth rate. For example, a company with a P/E of 15 and projected growth of +20% per year would have a PEG of 0.75 (15/20 = 0.75).
A simple rule of thumb: if a stock sports a PEG of less than 1.0, that’s a good value. Don’t buy simply based on that, though. You need to investigate further.
Although the PEG ratio is handy, it’s far from foolproof. Very high-growth companies can often sport PEG ratios above 1.0 yet still be decent long-term values. And don’t fall into the trap of believing that all companies with PEGs under 1.0 are good investments. After all, poor or unreliable growth estimates can easily throw off the calculation. .
2. Cash Flow/Enterprise Value (Cash Flow Yield)
A company is worth only the sum of the future cash flows it can generate. With this in mind, value-conscious investors should always examine a firm’s cash flows before investing.
As we mentioned earlier, the P/E ratio is not a perfect measure. A firm’s net income is merely an accounting entry. It is often impacted by several non-cash charges like depreciation. Also, companies can use a variety of accounting tricks to manipulate or distort their earnings from quarter to quarter. By contrast, cash flow measures the money paid out or received over a certain period.
Cash flows strip out the impact of non-cash accounting charges like depreciation and amortization. More importantly, cash flows are entirely objective. There is no value judgment about when and how revenues are recognized. The cash flow statement only recognizes the actual cash that flows into or out of a business. By excluding extraordinary one-time items (like asset sales), operating cash flow shows the true profitability picture of a firm’s core operations.
But keep in mind, evaluating cash flows in isolation makes little sense. We like to compare a company’s operating cash flow to its enterprise value. This gives us a better sense of the amount of cash a company generates each year relative to the total value investors have assigned to the firm.
For those unfamiliar, enterprise value (EV) reflects a firm’s true value more accurately than market capitalization. EV is calculated by taking a company’s market cap (price per share times the number of shares outstanding), then adding debt and subtracting the firm’s cash balance. This makes EV an excellent reflection of the total value an investor would receive if they purchased the entire firm. In other words, the investor would have to pay off a firm’s debt but would get to keep the cash on the books.
By dividing a company’s operating cash flow by enterprise value, we can calculate the firm’s operating cash flow yield (OCF Yield). This reflects how much cash a company generates annually compared to the total value investors have placed on the firm. All things being equal, the higher this ratio, the more money a company generates for its investors. Companies with high OCF yields are likelier to be excellent value stocks.
3. Return-On-Equity (ROE)
ROE is a favorite of Warren Buffett. The calculation is simple: divide a company’s net income (total profits after interest, taxes, and depreciation) by shareholder’s equity.
Shareholder’s equity is an accounting estimate of the total investment equity holders have made in a firm. It can be found as a line item on a company’s balance sheet. This ratio measures the company’s profit relative to shareholders’ investment in the firm. Because this measure is widely used, almost all financial websites list ROE values for publicly traded companies.
We like to see companies with stable or rising ROE in recent years. However, there are caveats. For example, suppose a company has a solid year (or books a one-time gain). Net income might be temporarily inflated, leading to exceptionally strong ROE values.
Another point to consider is the relationship between ROE and debt. By taking on higher and higher debt loads, companies can substitute debt capital for equity capital. Thus, companies with greater debt loads should be expected to have higher ROE than companies with cleaner balance sheets.
ROE and return on invested capital (ROIC) provide insight into how efficiently a company deploys its capital. Companies with a “grow at any cost” mentality can post respectable growth rates yet still destroy shareholder value. To weed out these firms, we typically prefer companies with ROE figures in the mid-teens or better — roughly the historical average of the S&P 500.
4. Discounted Cash Flow (DCF) Analysis
DCF modeling is a sophisticated analytical tool that many Wall Street pros use to gauge a firm’s intrinsic value. Essentially, the process involves forecasting a firm’s future cash flow stream and then discounting those cash flows back to the present at a rate sufficient to compensate investors for the risk taken. We can estimate the firm’s intrinsic value per share by adding the present values of all future cash flows and dividing them by the current number of outstanding shares.
As might be expected, the numbers that come out of this calculation are only as good as those that go in. Poor growth projections and unrealistic discount rates can yield wildly off-base intrinsic value figures. To minimize risk if future financial performance deviates from the assumptions baked into the calculation, most value investors demand a wide margin of safety before investing. In other words, they might not purchase a stock with an intrinsic value of $50 per share unless it trades at $40 or below. The higher the degree of uncertainty, the larger the required margin of safety.
DCF analysis can be a powerful tool to aid the value hunter when used with traditional valuation metrics like price-based ratios.
This article was originally published on this site