At a time when most investors are chasing the next hot stock or attempting to trade the short-term ebbs and flows of the market, value investing can seem a bit drab…

Yet some of the world’s most successful investors swear by it.

It’s also one of the few investment strategies grounded in sheer common sense. The core of value investing is simple: Buy shares of a solid business for less than they’re really worth.

Not only does this minimize downside risk, but as the market eventually recognizes the company’s true value, patient investors can reap handsome rewards.

But just because it’s simple doesn’t mean it’s easy.

Successful value investing requires independent thinking, meticulous research, and the discipline to tune out the crowd. That’s why having a clear, objective framework is critical in identifying genuine bargains amid the market’s noise.

Since taking the helm of Wealthy Retirement‘s Value Meter column, I’ve sought to help readers better gauge whether stocks are overvalued or undervalued in a way that isn’t endlessly complicated.

The father of value investing, Ben Graham, believed financial analysis should be simple, requiring no more than basic arithmetic. While the system behind The Value Meter uses a tad bit more than arithmetic, it does aim to be simple. In fact, it’s based on only three key metrics.

The Value Meter Criteria
The first metric gets to the heart of what makes a good business: the ability to generate profits. But what’s the best measure of profitability?

Reported earnings can be misleading. Massive one-time gains, shifting accounting policies, and management trickery can all distort a company’s true profitability. That’s why most value investors insist on following the cash.

Free cash flow is the primary (but not only) measure of profitability I look at. It represents the cash a company generates after subtracting operating expenses and capital expenditures.

Steady cash flow is the lifeblood of any business because it allows the company to fuel growth, reduce debt, and reward shareholders.

After I determine a company’s free cash flow, I like to compare it with the company’s net asset value, or NAV − the difference between its assets and its liabilities. This allows me to assess how efficiently the company is using its resources to generate cash.

The higher the ratio of free cash flow to NAV, the better.

For example, let’s say Company ABC and Company DEF both have $10 billion in net assets, but Company ABC brings in $40 billion in free cash flow while Company DEF brings in just $20 billion. This means Company ABC is twice as efficient as Company DEF at turning its assets into cash.

Once I’ve calculated this ratio over each of the past four quarters, I’m able to see where the company ranks among the roughly 6,000 U.S. exchange-traded stocks in my database.

The third key metric is the hypothetical cost of acquiring the entire business, also known as its enterprise value, or EV. Unlike market cap, EV accounts for a company’s total acquisition cost, including both equity and debt.

Just as I do with free cash flow, I compare each company’s EV with its NAV. A low EV/NAV ratio suggests that you’re paying relatively little to acquire the company – a hallmark of an undervalued stock. So the lower the figure, the better.

Lastly, I score each company by averaging its ranking for each measurement and using basic statistical analysis to assign it a rating on a scale from 0 to 6.

Those scores correspond to five different categories: “Extremely Undervalued,” “Slightly Undervalued,” “Appropriately Valued,” “Slightly Overvalued,” and “Extremely Overvalued.”

At the bottom of each of my Value Meter columns, you’ll find all of this information compiled into a simple graphic. Here’s an example:

Overall, my Value Meter system favors companies that are producing high levels of cash relative to their net assets while trading at low EVs relative to their net assets. If a company ranks well in both categories, that indicates that it’s both more efficient and cheaper than its peers.

Now, admittedly, my system isn’t perfect.

It clearly prefers asset-heavy companies with ample free cash flows, which are typically mature companies rather than those in the early growth phase.

As a result, it tends to not give positive ratings to fast-growing businesses that are light on capital, some of which turn out to be phenomenal investments. Most growth-focused investors would consider that a huge flaw.

But for anyone seeking a straightforward way to identify potentially mispriced companies, The Value Meter offers a solid start. Its unwavering focus on cash generation and asset value can help investors stay grounded.

Value investing is not the only way to build wealth in the markets, but it has proved its merits over many decades. The Value Meter’s aim is to make this timeless strategy more accessible than ever.

— Anthony Summers

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Source: Wealthy Retirement