4 Ways To Find Good Values In The Stock Market
While value investing can be highly profitable, no one ever said it was easy.
For starters, it can be pretty difficult to accurately determine the true intrinsic value of a firm. Such calculations always involve unknown variables and assumptions about the future that may or may not play out according to plan. Furthermore, 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 — meaning undervalued stocks can remain that way for extended periods before other investors finally catch on.
Nevertheless, all of this work can be well worth the effort. Yet if you ask most individual investors to explain their process for finding “good values,” they’ll likely mention P/E ratios. The discussion largely ends there. And while this widely used ratio provides an essential measure of a company’s stock price in relation to its earnings, there is much more to value investing.
While no single metric will allow investors to uncover the best value plays, our research staff considers several factors when looking for solid value candidates. Below, we discuss just a few of our favorites…
4 Ways To Find Value In The Stock Market
1. P/E-to-Growth Ratio (PEG)
By incorporating a firm’s expected future growth into the equation, PEG ratios help us to eliminate one of the major shortfalls of pure P/E comparisons — the effect of estimated growth. PEG ratios can be 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 is that stocks that sport PEGs of less than 1.0 are considered relatively decent values.
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. With these potential pitfalls in mind, investors need to consider other factors besides PEG ratios. (Since no perfect financial indicator exists, the same could be said of all other ratios.)
2. Cash Flow/Enterprise Value (Cash Flow Yield)
As we explained above, a company is worth only the sum of the future cash flows it can generate from its business. 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. As such, 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 by a company over a certain period.
Cash flows strip out the impact of non-cash accounting charges like depreciation and amortization. And 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.
Again, though, it makes little sense to evaluate cash flows in isolation. Always mindful of valuation levels. 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 (both debt and equity) investors have assigned to the firm.
For those unfamiliar, enterprise value (EV) is a way of adjusting market capitalization to reflect a firm’s true value more accurately. EV is calculated by taking a company’s market capitalization (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 — 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 measure 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 much more likely to be excellent value stocks.
3. Return-on-Equity (ROE)
ROE provides investors with another excellent tool to help uncover value stocks and is a favorite of Warren Buffett. The calculation of ROE is simple: divide a company’s net income — defined as total profits after interest, taxes, and depreciation — by its 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 most publicly traded companies.
When searching for value-oriented investment ideas, we typically look for companies that have shown stable or rising ROEs in recent years. However, there are caveats. For example, suppose a company has a particularly strong year (or books a one-time gain). In that case, its net income can 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.
The ROE measure and return-on-invested capital (ROIC) provide insight into how efficiently a company deploys its capital. Those 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 rather 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, 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 up 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 the numbers 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 was trading 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 in conjunction with traditional valuation metrics like price-based ratios.
Editor’s Note: If you’re looking for “the next big thing” that could lead to life-changing returns, then you need to see this…
Our colleague Jimmy Butts has discovered the next big disruptive trend that could change our everyday lives as we know it: flying cars. It may sound like science fiction. But it’s much closer to becoming a reality than you think. They’re ready to hit the skies and disrupt the entire global auto industry. Major aviation firms (and some serious tech brainpower) are lining up behind one company whose ground-breaking flying car technology could be unleashed on the world very soon. Click here for details.