Value investors get a bad rap. Sometimes, value investing is referred to as “cigar butt” investing, in that picking up cheap, undervalued stocks is equivalent to picking up mostly smoked cigars off of the sidewalk. A good friend and colleague of mine used to call me a “dumpster diver”. Guilty.
The old Wall Street maxim “buy low, sell high” is in direct conflict with “buy high, sell higher”.
Typically, value stocks are less volatile than growth stocks. That doesn’t mean they’re less risky.
I’m not going to argue the outperformance of growth versus value. Sometimes growth outperforms. Sometimes value outperforms. I’m also not going to get lost in the weeds of grandfather of value investing Benjamin Graham’s notion of intrinsic value and margin of safety.
What I will do is point out three key indicators that will get the ball rolling in evaluating a value stock.
1. Forward P/E
I’ve found that the most useful metric used in determining a stock’s value is the price-to-earnings ratio (P/E). A stock’s P/E ratio measures its price relative to the underlying business’s earnings per share (EPS). The trailing P/E measures past earnings while the forward P/E is calculated with projected earnings. The forward P/E is my go-to valuation metric. A low forward P/E is an indicator of the marketplace’s confidence in the ability of the company to deliver on the earnings forecast. The lower the number, the less confident the market is, and thus the cheaper the stock.
It’s also helpful to compare the stock’s forward P/E to that of the benchmark. If the S&P 500’s average forward P/E is 23 and the stock you are considering has a forward P/E of 14, that stock is trading to a 39.1% discount to the market on a forward P/E basis and could be a good value. You can (and should) also compare a stock’s forward P/E to those of its industry peers.
2. Price To Sales
Another useful metric is the price-to-sales ratio (P/S). P/S measures a company’s market cap versus its annual revenue number. The idea is that the lower the number, the greater the implied value. For example, Snap, Inc. (SNAP) trades at 18.15 times sales, an expensive number. However, aftermarket auto parts giant Genuine Parts (GPC) trades at just 0.81 times sales — 81 cents to every dollar of sales the company brings in. Often, the lower the number, the more inefficiently the market has mispriced the stock.
3. Hidden assets
This is a tricky one. Usually, these assets aren’t exactly hidden. They show up on the balance sheet and in the financial reports. However, due to the company’s stock being out of favor, the market in its infinite herd mentality is either deeply discounting or possibly altogether ignoring the obvious value of a crucial, tangible asset. It could be something as simple as cash on the books, a subsidiary, or, more often than not, real estate.
Action To Take: These three criteria just scratch the surface of value investing which, as an investment discipline has many nuances. While this is enough to get you started, the most important aspect of value investing is patience. Don’t buy without it.
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Source: Street Authority