Value investors use stock metrics to help them uncover stocks they believe the market has undervalued. Investors who use this strategy believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with a company's long-term fundamentals, giving investors an opportunity to profit when the price is deflated.
Although there's no "right way" to analyze a stock, value investors turn to financial ratios to help analyze a company's fundamentals. In this article, we'll outline a few of the most popular financial metrics used by value investors.
Key Takeaways
- Value investing is a strategy for identifying undervalued stocks based on fundamental analysis.
- Berkshire Hathaway leader Warren Buffett is perhaps the most well-known value investor.
- Value investors use financial ratios such as price-to-earnings, price-to-book, debt-to-equity, and price/earnings-to-growth to discover undervalued stocks.
- Free cash flow is a stock metric showing how much cash a company has after deducting operating expenses and capital expenditures.
- Value investing is a style of investing championed by Benjamin Graham in the first half of the 20th century.
Price-to-Earnings Ratio
The price-to-earnings ratio (P/E ratio) is a metric that helps investors determine the market value of a stock compared to the company's earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings.
The P/E ratio is important because it provides a measuring stick for comparing whether a stock is overvalued or undervalued. A high P/E ratio could mean that a stock's price is expensive relative to earnings and possibly overvalued. Conversely, a low P/E ratio might indicate that the current stock price is cheap relative to earnings.
Since the ratio determines how much an investor would have to pay for each dollar in return, a stock with a lower P/E ratio relative to companies in its industry costs less per share for the same level of financial performance than one with a higher P/E ratio. Value investors can use the P/E ratio to help find undervalued stocks.
Please keep in mind that with the P/E ratio, there are some limitations. A company's earnings are based on either historical earnings or forward earnings, which are based on the opinions of Wall Street analysts. As a result, earnings can be hard to predict since past earnings don't guarantee future results and analysts' expectations can prove to be wrong. Also, the P/E ratio doesn't factor in earnings growth, but we'll address that limitation with the PEG ratio later in this article.
P/E ratios are useful for comparing companies within the same industry, not companies in different industries.
Price-to-Book Ratio
The price-to-book ratio or P/B ratio measures whether a stock is over or undervalued by comparing the net value (assets - liabilities) of a company to its market capitalization. Essentially, the P/B ratio divides a stock's share price by its book value per share (BVPS). The P/B ratio is a good indication of what investors are willing to pay for each dollar of a company's net value.
The reason the ratio is important to value investors is that it shows the difference between the market value of a company's stock and its book value. The market value is the price investors are willing to pay for the stock based on expected future earnings. However, the book value is derived from a company's net value and is a more conservative measure of a company's worth.
A P/B ratio of 0.95, 1, or 1.1 means the underlying stock is trading at nearly book value. In other words, the P/B ratio is more useful the greater the number differs from 1. To a value-seeking investor, a company that trades for a P/B ratio of 0.5 is attractive because it implies that the market value is one-half of the company's stated book value.
Value investors often like to seek out companies with a market value less than its book value in hopes that the market perception turns out to be wrong. By understanding the differences between market value and book value, investors can help pinpoint investment opportunities.
Debt-to-Equity Ratio
The debt-to-equity ratio (D/E) is a stock metric that helps investors determine how a company finances its assets. The ratio shows the proportion of equity to debt a company is using to finance its assets.
A low debt-to-equity ratio means the company uses a lower amount of debt for financing versus shareholder equity. A high debt-equity ratio means the company derives more of its financing from debt relative to equity. Too much debt can pose a risk to a company if they don't have the earnings or cash flow to meet its debt obligations.
As with the previous ratios, the debt-to-equity ratio can vary from industry to industry. A high debt-to-equity ratio doesn't necessarily mean the company is run poorly. Often, debt is used to expand operations and generate additional streams of income. Some industries with a lot of fixed assets, such as the auto and construction industries, typically have higher ratios than companies in other industries.
Free Cash Flow
Free cash flow (FCF) is the cash produced by a company through its operations, minus the cost of expenditures. In other words, free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures (CapEx).
Free cash flow shows how efficient a company is at generating cash and is an important metric in determining whether a company has sufficient cash, after funding operations and capital expenditures, to reward shareholders through dividends and share buybacks.
Free cash flow can be an early indicator to value investors that earnings may increase in the future, since increasing free cash flow typically precedes increased earnings. If a company has rising FCF, it could be due to revenue and sales growth, or cost reductions. In other words, rising free cash flows could reward investors in the future, which is why many investors cherish free cash flow as a measure of value. When a company's share price is low and free cash flow is on the rise, the odds are good that earnings and the value of the shares will soon be heading up.
PEG Ratio
The price/earnings-to-growth (PEG) ratio is a modified version of the P/E ratio that also takes earnings growth into account. The P/E ratio doesn't always tell you whether or not the ratio is appropriate for the company's forecasted growth rate.
The PEG ratio measures the relationship between the price/earnings ratio and earnings growth. The PEG ratio provides a more complete picture of whether a stock's price is overvalued or undervalued by analyzing both today's earnings and the expected growth rate.
Typically a stock with a PEG of less than 1 is considered undervalued since its price is low compared to the company's expected earnings growth. A PEG greater than 1 might be considered overvalued since it might indicate the stock price is too high compared to the company's expected earnings growth.
Since the P/E ratio doesn't include future earnings growth, the PEG ratio provides a more complete picture of a stock's valuation. The PEG ratiois an importantmetric for valueinvestors since it provides a forward-looking perspective.
What Are the Basics of Value Investing?
Value investing is not a new strategy and involves a number of calculations and assumptions about the future performance of a business compared to its current share price. At its core, value investing is finding stocks that, even in a strong bull market, are considered undervalued by the market. This usually happens when the market moves significantly and a stock price follows the market, without the core business being affected in any way. A value investor would notice the stock's price is low relative to its real value, and purchase the stock.
Is Value Investing a Long-term Strategy?
Value investing is usually a long-term strategy, although some traders will base shorter-term trades on a value strategy. Since value investing considers certain aspects of a publicly-traded company that tend to move slowly, value investing is usually used as a buy-and-hold strategy or sometimes as a swing trade, but usually isn't the basis for short-term trading styles like day-trading or high-frequency trading.
Who Is the Father of Value Investing?
Value investing is a strategy credited to and used to great success by Benjamin Graham. Due to Graham losing his entire investment portfolio in the Stock Market Crash of 1929 (which lead to the Great Depression) he developed a system for arriving at an intrinsic value for stocks rather than simply considering that stock's current market price. His book, The Intelligent Investor, went on to sell many copies and inspire an investing great, Warren Buffett.
The Bottom Line
No single stock metric can determine with 100% certainty whether a stock is a value or not. The basic premise of value investing is to purchase quality companies at a good price and hold onto these stocks for a long duration. Many value investors believe they can do just that by combining several ratios to form a more comprehensive view of a company's financials, its earnings, and its stock valuation. Value investors invest in the stock of these companies and use value mutual funds and ETFs.
