As a value investor, I hate to overpay. That’s not just true of stocks, but pretty much anything else… tools, lawn equipment, you name it. My kids call that cheap, but they don’t really understand.

The goal isn’t just to buy the cheapest option in any particular category. In some cases, I buy the top-of-the line model.

[ad#Google Adsense 336×280-IA]What matters is the relationship between price (what you pay) and value (what you get). In short, I strive to get my money’s worth and maximize my returns.

But how do we determine value? Price is right there in black and white, but value can be much harder to quantify.

Usually, the best way to approximate what an asset is worth involves comparisons to similar items.

In real estate, home appraisals are based on comparisons to other properties of similar age and square footage in the surrounding neighborhood. And if you’re trying to assess the value of a pre-owned 2009 Honda Accord, there are resources to see what other buyers have paid for that particular make and model.

Armed with this information, you have a much better idea of whether you’re getting a great deal or need to keep shopping around.

Unfortunately, there is no Kelley Blue Book to tell us what a stock is worth. So we compare the company’s price to others in the same line of work.

I own Occidental Petroleum (NYSE: OXY) in my Total Yield portfolio. It is trading at 11.08 times trailing earnings. That’s just half the industry average of 22.49. And the company has been increasing its dividends at 16.17% annually, much faster than the 2.53% pace of its peers.

By this measure, Occidental looks like an attractive buy. But such comparisons don’t tell us anything about the stock’s absolute value, only its value relative to others (which themselves may or may not be expensive). Plus, we haven’t compensated for differences in operating expenses, capital structure, profit margins and other factors.

That’s why it pays to go a step further. Don’t just compare what Occidental costs in relation to others, but in relation to what the company owns.

Looking at the last balance sheet, the firm has $2.9 billion in cash, $4.9 billion in receivables and $2.6 billion in liquid inventory, for total current assets of $10.5 billion. There is another $61 billion on the books in property, plant, equipment and investments. That adds up to total assets of $71.5 billion.

After deducting debts and liabilities, Occidental has stockholder’s equity of $44.1 billion. With 775 million shares outstanding, that gives us a book value of $56.90 per share. Theoretically, that’s the residual value — the net amount that common shareholders would receive in the event of liquidation after all the bills had been paid.

In actuality, buildings, equipment and other long-term assets are sometimes sold at auction or fire-sale prices and don’t get full face value. That’s why Ben Graham (Warren Buffet’s mentor and the father of value investing) espoused investing in companies trading for less than their net current asset value (basically cash and liquid inventory minus liabilities).

Imagine a printing company that owed $6 million, but had $8 million in the bank or quickly convertible to cash (excluding equipment). Even if the business went bankrupt, stockholders could pay off creditors and still have at least $2 million left over.

If that company had a market cap below $2 million, then Graham would have been interested. Specifically, he demanded an even larger margin of safety by looking for businesses trading at less than two-thirds of their net current asset value.

One study conducted by New York University between 1970 and 1983 found that these underpriced stocks delivered an average annual return of 29.4%.

These days, though, such stocks are few and far between. Most companies trade for more than book value. Why? Because as a part-owner, you’re not just investing in the business for what it’s sitting on today, but the earnings it can generate tomorrow. So future growth assumptions are often baked into the price.

The faster the bottom line is growing, the bigger the premium to book value. The average stock in the S&P 500 is priced at 2.8 book. Google (Nasdaq: GOOG) is trading at 3.46 times book value. The company’s assets (net of liabilities) total $153 per share, but the stock trades at $530.

That doesn’t mean GOOG can’t make money from here, but buying here places a lot of faith in tomorrow.

But when a business is trading for less than the sum of its spare parts, the guesswork is taken out of the picture. Any future growth is essentially free. That usually minimizes the downside and provides a skewed risk/reward in favor of the latter.

With that in mind, I went out in search of high-quality, shareholder-friendly businesses that are earning consistent profits and sharing it with investors (Total Yields of 6% or greater) and trading for less than book value.


Action to Take: I didn’t feel the need to include them all in the table above, but there were numerous energy companies that passed this screen after the sector was crushed by falling oil prices.

Offshore driller Ensco (NYSE: ESV) is now trading for about half the value of its net assets. In theory, that means that even if the company went under, stockholders could liquidate the assets, pay off the bills and have $50.51 per share left over. So anyone who invested here at $30.19 would nearly double their money.

Of course, you can’t invest blindly. With price-to-book below 1.0, the market is signaling the expectation that these businesses may be worth less tomorrow than today. Sometimes that may be true; other times sellers are simply panicked.

Of these, I’m currently most interested in GTECH (OTC: GTKYY), which sells lottery terminals and equipment and is involved in other activities such as sports betting and online gaming. The company was the high bidder for slot machine maker International Game Technology (NYSE: IGT), one of my former holdings that rocketed 27% last June following the buyout announcement.

IGT may be even more valuable in the hands of a larger global partner than it was as a standalone company. And that partner is trading at a 10% discount to its book value and has a Total Yield north of 11%.

— Nathan Slaughter

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Source: Street Authority