Value investing is a very popular stock strategy
where investors seek out companies that they believe have the ability to create
profits at an acceptable level during a sustained holding period. An acceptable
level of profits would probably mean doing better than the market average,
but it would be different for every investor. What is the same for all value
investors is the desire to buy a well performing stock at a bargain price.
For value investors, simple market factors that can
cause fluctuations in stock prices are not of great concern. Common market
factors which tend to affect stock prices are: inflation reports, Fed rate
hikes, oil prices, and wars. While it is true that market factors will affect
stock prices, value investors tend to look further down the road and,
therefore, believe temporary fluctuations will not affect long-term
profitability – when owning ‘value stock.” In fact, the “buy and hold” stock
strategy is employed by most value investors because they tend to hold onto
value stocks for many years at a time. Where the two strategies differ is in
their selection of stock.
Value investors are not concerned with market
factors as much as the actual companies in which they are investing. In fact, a
value investor likes to know the “fundamentals’ of a company – or all factors
relevant to the business and its relative strength in the market. Some very
useful fundamentals for value investors to know include: cash flow, earnings
growth, dividends, and company debt.
However, just because a company is sound in all of
the categories listed above, that does not mean it would be considered a value
stock investment opportunity. A company with great cash flow, solid, consistent
earnings growth, reasonable dividends and relatively little to no company debt
– may actually be a growth stock investment and therefore not desired by a
value investor.
The value investor is looking for the best deal: a
company with sound fundamentals but, trading below its “true value” for some
reason. The market should eventually correct its inaccurate valuation and, send
stock prices sharply upward when that correction occurs. This is why value
investors comb the markets for great companies that have been missed by
analysts and the investment community.
But, finding a good investment that appears
undervalued by the market (and therefore trading at a price below its true
worth) is not the same as buying cheap stocks or those that have already
peaked and won’t recover. There is usually a fundamental reason behind the
decrease in the market value of a company and the consequent plummet in stock
prices: essential business principles or operations may have changed (such as
decreased earnings, loss of market share, etc.). Fundamental market changes
will also cause fluctuations in value, such as government imposed new emissions
regulations on the auto industry that would severely increase the costs of
production for all automakers.
Analysis in Value Investing Stock Strategy
As the value investor is trying to find good
companies with strong growth and earnings potential that have been overlooked
by the market somehow, a lot of homework and analysis will be necessary. The
trick for anyone using the value investing stock strategy is to find the true
value of the company as opposed to its “market value.” A number of factors are
used to determine the true value of a company and each investor will have their
own “winning formula.” Some common valuation metrics for value investors are:
Price/Earnings
Ratio (P/E Ratio) - The P/E ratio can be used to determine how the earnings of a
business compare with the current share price. It is obtained by dividing the
current stock price by the annual earnings per share. The higher a company’s P/E ratio, the greater
the expectations placed upon it by investors in the near future. These higher
expectations also drive up stock prices, which is why investors using the value
stock strategy do not like high P/E ratios as they may indicate that the company is over
valued by the market. This is precisely the opposite of what a value investor
is looking for – instead, the value stocks tend to be those that have a P/E ratio in the bottom 10-20% of their business sector.
PEG - The PEG is a valuation metric concerned with future earnings
growth. The PEG factors in future growth rates with the P/E ratio. It is
calculated by dividing the P/E ratio by the projected growth in earnings for the coming
year.
PEG = P/E Ratio / Projected Growth in Earnings
For instance, assume that Business A has a P/E ratio of 15 with projected earnings of 12%, or
15/12. Most value investors like companies with a PEG of 1 or less because it
is a good indicator of being under valued by the market. Business A has a PEG
of 1.25 which means that investors are willing to pay more for future earnings
growth than a company with a PEG of 1 or less. Essentially, the market already
recognizes the value in company A and, the stock prices have risen accordingly.
Thus, company A would not be considered a value investment but, may still be a
solid growth stock worthy of investment. The higher the PEG number, the more
expensive the investment and the less likely a value investor will be
interested in owning stock in that company.
Solid Earnings Growth over an Extended Time
It is not uncommon for a company to have great
earnings over a period of 6-8 years and, then decide its time to take the
business public. After a great IPO, the business may stagger and fail to meet
earnings or revenue expectations. As a result, the stock may nose dive and fall
out of favor with the investment community. Value investors, however, see this
as a potential opportunity: solid and sustained earnings growth is no accident
– the company knew what it was doing before and, one or two bad quarterly
reports don’t necessarily spell disaster. In fact, they may be due to massive
investments in the company that may result in increased profits, higher
dividends, and higher stock prices in the not-so-distant future. If a company
can maintain 7-10% earnings growth over a period of 5-6 years or more, then one
or two misses can probably be explained by some temporary factors. So long as
the fundamentals remain solid and any poor performance is explained
sufficiently, a value investor would consider this a value stock with the
prospect of solid future earnings growth as well.
Intrinsic Value
Determining the value of a business used to be
fairly straightforward: add up all the assets, subtract any outstanding debt
and financial obligations – whatever remains is the value of the company. Value
investors need to look beyond the obvious assets and market position of
businesses – especially in the Information Age.
It is difficult, if not impossible, to put an
accurate value on intellectual property, developing technology, and any
knowledge based asset. How do you know what a patent is truly worth when you
don’t know what future sales will actually be? How many sales are made because
of a trademark or logo – what if you had to put a dollar amount on how much
that trademark is worth? Sometimes, these corporate “intangibles” do not even
show up on the financial statements. Value investors seek out and purchase
stocks when they believe that current share prices do not accurately reflect
the value of intangibles and their potential to affect future growth. When the
market corrects based off of higher-than-expected earnings and revenue, the
stock prices will rise nicely and handsomely increase investor profits.
To find the intrinsic value of a company, investors
need to determine the market cap – or establish how much it would cost to buy
every single share of company stock at current market prices. This is the total
value of the company according to the market – including intangibles,
fundamentals, and market conditions. A value stock generally has a market cap
which is close to or maybe even lower than the book value.
The book value of a company is found by totaling
assets and, subtracting all obligations and liabilities. If the assets had to
be liquidated and all the debts paid off, how much would be left? That is the
book value of the company. The market cap will exceed the book value by a fair
margin in growing companies because of their ability to generate earnings
growth – often due to intangibles such as patents, trademarks, or other
intellectual property that gives them an advantage over the competition.
Value investors use a number of valuation metrics
and analysis to help find stocks that are under valued today, but are destined
to rise once the market corrects its mistake in the future. P/E ratio, PEG, earnings
growth, and intrinsic value are just some of the variables that value investors
look at when trying to find the best bargain stocks on the market.