Some of the first investing strategies you may come across are buy-and-hold, income investing, and growth investing. And, as you dive in deeper and begin to better understand the tools of stock analysis, you’ll soon come across the value investing strategy.
Famous as the strategy that led to riches for billionaire Warren Buffett and his mentor, Benjamin Graham, the value investing strategy focuses on the use of several valuation metrics, often comparing stock price to company performance.
The goal is to find stocks with an intrinsic value, or perceived value, that’s higher than the current market price, suggesting you have access to discounted shares.
By buying shares at a discounted price and waiting for the value of the stock to reach a more realistic level, investors earn outsize returns on the upswing.
Metrics Value Investors Should Pay Attention To
If you’re going to get involved in investing in value stocks, it’s important to understand how to find the intrinsic value of a stock and determine the answer to the biggest question posed by the strategy:
Is the security undervalued, overvalued, or trading at fair market value?
To answer this question, the most successful value investors use a series of valuation metrics comparing the price of the stock to the performance of the company.
Through the use of various ratios, you can measure the value of a company in comparison to its peers and know whether there’s reason to expect growth in the value of the stock.
1. Price-to-Earnings Ratio (P/E Ratio)
Perhaps the most important metric for most value investors is the price-to-earnings ratio, or simply P/E ratio.
P/E ratio compares the price of the stock to the company’s earnings per share, or EPS, over a 12-month period. This lets you compare the price you pay for a unit of profits from one stock to another.
To determine the P/E ratio of a stock, simply divide the share price by the company’s reported earnings per share.
There are three ways to calculate P/E ratios by measuring different 12-month periods:
- Trailing P/E. Trailing ratios compare earnings generated over the past 12 months to the current price of the stock.
- Forward-Looking P/E. Forward-looking ratios compare future earnings expectations for the next 12 months to the current stock price.
- Mixed P/E. Often regarded as the most accurate ratio, the mixed P/E ratio compares the past six months’ earnings plus expected earnings over the next six months to the current price of the stock.
Value investors are looking for a low P/E ratio — a low price for each unit of earnings. All you need to do is compare the current P/E ratio of the stock to the average P/E in its industry.
For example, according to TipRanks, the average P/E ratio in the tech sector is 17. So, a tech stock with a P/E ratio of 10 could be considered highly undervalued or inexpensive, and one with a ratio of 23 could be considered overvalued or at least a bit pricey.
Pro tip: How would you like help picking great investments? Enter Motley Fool Stock Advisor. This is one of the best stock picking services available for investors. Motley Fool Stock Advisor picks have returned 597% compared to just 127.8% for the S&P 500.
2. Price-to-Book-Value Ratio (P/B Ratio)
The price-to-book-value ratio, or P/B ratio, compares the price of the stock to the current book value of the company — the total value of the company’s assets minus any liabilities — on a per-share basis.
The formula for calculating P/B ratio is very simple:
P/B Ratio = Share Price ÷ Book Value Per Share
You’ll start by determining the value of the company on a per-share basis. To do so, divide the total net assets on the company’s balance sheet by the number of outstanding shares. For example, if a company has $100 million in net assets and 10 million shares outstanding, the book value per share is $10.
For this example, let’s say the stock’s price is $50. To determine the P/B ratio, you would divide the $50 stock price by the $10 book value per share, coming to a P/B ratio of 5.
This number may not mean much in the abstract but, like P/E ratio, it’s helpful to compare against a stock’s peers.
If the stock in our example traded in the tech sector, where according to CSI Market the average stock trades with a P/B ratio closer to 19, our P/B ratio of 5 suggests an incredible undervaluation. This scenario suggests the market hasn’t yet fully priced in the value of the company’s assets.
3. Price-to-Sales Ratio (P/S Ratio)
The price-to-sales ratio, or P/S ratio, compares the price of the stock to the sales the company generates on a per-share basis over the course of a year.
Like other ratios on this list, the price-to-sales ratio can be calculated on a trailing, forward-looking, or mixed 12-month basis. To calculate the P/S Ratio, using the following formula:
P/S Ratio = Company’s Stock Price / (Annual Revenue / Shares Outstanding)
For example, if a stock trades at $5 per share, represents a company with 50 million shares outstanding, and generates $100 million in annual revenue, the formula would look like this:
P/S Ratio = $5 ÷ ($100,000,000 ÷ 50,000,000) = 2.5
In general, price-to-sales ratios below 1 suggest the stock is undervalued. Ratios between 1 and 2 suggest the stock is priced fairly, and ratios above 2 suggest that the stock is currently overvalued.
Considering the P/S ratio of 2.5 in the above example, the stock would be considered overvalued and would not be a strong option for value investors.
4. Price/Earnings-to-Growth Ratio (PEG Ratio)
Many believe the PEG ratio provides a more accurate depiction of valuation than the P/E ratio because it provides the same data while factoring in not only the current price of the stock and the company’s net income but also its expected earnings growth rate.
A lower PEG ratio suggests you’re paying less for each unit of anticipated earnings growth.
Here’s the formula for the PEG ratio:
PEG Ratio = P/E Ratio ÷ Earnings Growth
For example, let’s say you’re comparing what you believe to be the intrinsic market value of two stocks.
Company A trades at $50 per share, generated $1.83 per share in earnings last year, and is expected to generate $2.04 per share in earnings this year. Company B trades at $85, produced $2.89 per share in earnings last year, and is expected to generate $4.01 in earnings per share this year.
Here’s how it would all work out:
- Determine P/E Ratios. Company A’s P/E ratio is 27.32, or $50 ÷ $1.83. Company B has a P/E ratio of 41.67, or $85 ÷ $2.89. Simply using this ratio, Company A would be the clear winner when it comes to offering a lower valuation.
- Calculating Earnings Growth. To determine the growth rate of the company, divide this year’s expected earnings per share by last year’s EPS, then subtract 1 from the answer. So, for Company A, divide this year’s protected earnings of $2.04 by last year’s earnings of $1.83 to get a value of 1.11. Then, subtracting 1 from the total, you’ll get Company A’s growth rate: 11%. Using the same math, the growth rate on Company B comes to about 39% (($4.01 ÷ $2.89) – 1).
- PEG Comparison. For Company A, calculate PEG ratio by dividing its P/E ratio (27.32) by its earnings growth rate (11); you’ll come to a PEG ratio of 2.48. Using the same math, Company B’s PEG ratio comes to 1.06. So, although a classic price-to-earnings comparison says Company A is a better bargain, a more detailed analysis using PEG points to Company B as the clear winner once expected earnings growth is factored in.
5. Debt-to-Equity Ratio (D/E Ratio)
The debt-to-equity ratio is more of an overall financial metric than it is a valuation metric, but no matter what your style of investing might be, it’s an important factor to consider when making investment decisions.
The D/E ratio compares the company’s total amount of debt with the amount of shareholder equity, which can be found on the balance sheet of a company’s financial statement. The ratio is used to determine the company’s financial leverage, or its ability to pay off all its current debts.
High D/E ratios point to companies that finance their operations through debt rather than using funds they earn through their business. This can be a red flag that a company is in financial trouble or would be unable to repay its debts if economic fortunes turn. As such, it’s best to invest in companies with low debt-to-equity ratios.
6. Free Cash Flow (FCF)
In any business, cash will flow in and out. When more cash flows in than flows out, free cash flows, or FCF, will be positive. If more is flowing out than flowing in, FCF will be negative.
When investing, regardless of the strategy you follow, it’s important to look for companies with positive FCF that are consistently growing, because this suggests the stock is on strong financial footing and is able to finance its operations while increasing its wholly-owned cash.
Value investing is one of the most popular investing strategies today. Pioneered by Benjamin Graham in the 1920s, the strategy has led to wealth for many and has been the catalyst that brought many investors, including Warren Buffett, to riches.
The financial ratios above were all designed to tell you whether you are overpaying, underpaying, or getting a fair price in the stock market. By using them as part of your research when making investment decisions, you’ll increase your chances of success.