Value investing involves buying undervalued stocks in the market and selling them when the prices adjust to reflect their intrinsic (actual) value. Unlike some other trading strategies, value investing is more concerned about the long-term fundamentals of a business rather than short-term shifts in stock market prices.
Prices in the stock market are always fluctuating for one reason or another. However, such changes, whether positive or negative, usually don’t correspond to a change in a company’s fundamentals. The task of a value investor is to identify stock prices that have dipped for other reasons other than a decrease in the company’s valuation.
How to Identify Value Stocks
As easy as it may sound, identifying value stocks is easier said than done. Over the years, successful investors have developed a variety of strategies to invest in undervalued stocks. One of the most popular methods was developed in the 1920s by the famous economist Benjamin Graham, who is considered the father of value investing.
Graham’s strategy has arguably stood the test of time and was published 60 years ago in his book “The Intelligent Investor.” Many economists including Warren buffet and Christopher Browne have successfully employed his knowledge. The strategy, which has significantly influenced this article, has been adapted and adjusted to fit current trends over the years. You can use the following metrics to identify quality value stocks.
· Price to Earnings Ratio
You can learn very little by looking at a stock’s price. P/E ratio will enable you to measure the price of the stock against its earnings per share. Some investors will choose to look at earnings over the last 12 months, while others will look at projected earnings for the year ahead. But it is better to consider both to get a more accurate picture. Look for P/E ratios of 9.0 or less.
· Cash Flow Yield
Operating cash flow yield (OCF) is calculated by dividing a firm’s operating cash flow against its enterprise value. The higher the cash flow yield, the more the prospect of value stocks. Compared to P/E ratio, OCF is a much better indicator of a value stock since it is not impacted by non-cash accounting charges such as amortization and depreciation. But you should never use any of these metrics in isolation. This is not a common information that you can get easily. Only reputable brokers like FXCM and AxiTrader provide this information for free.
· Return on Equity
To calculate ROE, divide a business’s net income by its shareholders' equity. A company could have excellent growth rates but still register decreased shareholder value. ROE will enable you to filter out such companies when looking for value stocks. The ROE values for majority of public traded companies are available on financial websites.
· Debt to Asset Ratio
A low debt to asset ratio is an indication of a good value stock. You can easily calculate this ratio by dividing a company’s total debt against its total assets. A company should have more assets than it has debts. According to Benjamin Graham, you should look for companies with a debt to asset ratio of less than 1.10.
· Quality Rating
Choose a stock with an S&P rating of B or better. Standard and Poor’s ratings are highly revered in the industry with A+ being the highest rating and D the lowest. You can easily access the stock rating by visiting the S&P website.
Check to see whether the company pays adequate dividends to its shareholders. As is the nature of value investing, you might have to wait for a long time for other investors to catch up for the undervalued stock to attain to its intrinsic value or become overvalued. Ensure you are earning some profit in form of dividends as you wait for this to happen.
Discounted Cash Flow Analysis
While investors continue to use Graham’s metrics and their valuations to pick value stocks. Several other alternative methods have cropped up along the years. The Discounted Cash Flow formula is one of the most popular ones. The sophisticated analytical tool has become a favorite for many Wall Street investors. The method is predicated on the idea that the money available at present is more valuable now than in the future since it can be invested to generate more money.
Unfortunately, there is no one perfect formula that you can use to identify value stocks. Different investor will use different strategies and methods to pick profitable stocks. However, some will base them on gut feelings and hunches rather than objective facts. As a result, value investing is a mixture of both science and art.
With that said, value investing is a solid investment strategy that has been successfully employed by many investors, including the greats such as Benjamin Graham and his student Warren Buffet, Charlie Munger, and David Dodd. All these have utilized the methods listed above to achieve their great success.