With the art of picking lowly valued stocks playing such a central role in any value investing strategy, it is essential for the investor to get acquainted with the necessary tools to make a proper assessment. While not many investors managed to make it to accountancy school, there are a few shortcuts available to understand a company’s valuation and its business quality.
These generally come down to understanding a few simple ratios that help isolate both cheap stocks in terms of valuation ratios, but also good stocks in terms of their operating ratios.
When an investor buys a company he’s buying the company’s assets but also a claim on the future earnings of that company. As a result it’s unsurprising that the top two things that Value Investors try to do is to buy assets on the cheap or earnings on the cheap.
While some financiers specialise in evaluating these things in extremely complicated ways, plenty of star investors such as David Dreman and Josef Lakonishok have had great success just focusing on the simplest ratios like the P/E Ratio and P/B Ratio which we describe in this article.
When using valuations ratios such as these its important to take a couple of things into account. Firstly, investors should compare the ratio for the company in question against the market and the sector peer group but also against the company’s own historical valuation range. By doing this the investor can not only find cheap stocks in the current market environment but also make sure they aren’t being caught up in frothy overall valuations.
There are risks to using these kinds of ‘relative valuation’ ratios that we’ll discuss in a forthcoming article, but nonetheless the following six ratios are essential weapons to keep sharpened in the armoury.
1. Price to Book Value – buy assets on the cheap
The P/B ratio works by comparing the current market price of the company to the book value of the company in its balance sheet. Book Value is what is left over when everything a company owes (i.e. liabilities like loans, accounts payable, mortgages, etc) is taken away from everything it owns (i.e. assets like cash, accounts receivable, inventory, fixed assets).
It is worth noting that this book value often includes assets such as goodwill and patents which aren’t really ‘tangible’ like plant, property and equipment. Some investors remove such ‘intangible’ assets from calculations of P/B to make the more conservative Price to Tangible Book Value (P/TB).
The P/B ratio has an esteemed history. As it doesn’t rely on volatile measures like profits and has a hard accounting foundation in the company’s books, it has often been used as the key barometer of value by academics.
The lowest decile of P/B stocks, similarly to low P/E stocks, have been found to massively outperform the highest P/B stocks by an average of 8% per year highly consistently. Most Value Investors try to buy stocks at a discount to their Book Value – or when the P/B ratio is at least less than 1.
We’ll be looking at several of Ben Graham’s more obscure and arcane ways of buying assets on the cheap in another article.
2. Price to Earnings Ratio (P/E) – buy earnings on the cheap!
Much maligned by many as an incomplete ratio that only tells half a story, the P/E ratio is nonetheless the most accepted valuation metric among investors.
By dividing a company’s stock price by its earnings per share, investors get an instant fix on how highly the market rates it. It is effectively shorthand for how expensive or cheap a share is compared with its profits.
Celebrated contrarian investor David Dreman put the P/E at the top of his list of criteria for selecting value stocks. In a study that spanned from 1960 through to 2010 Dreman found that stocks in the lowest 20% of PE ratios outperformed high P/E ratio stocks by an astonishing 8.8% per year! Not only that but he found that low P/E stocks outperformed in 70% of calendar years. Investing in such a strategy might miss the glamour growth ‘stars’ but who wouldn’t want to place their bets on those kinds of odds!
The ultimate value investor’s take on the P/E is known as the CAPE or cyclically adjusted P/E ratio. It takes takes the current price and divides it by the average earnings per share over the last 10 years. Sometimes current earnings can be overly inflated due to a business boom so the CAPE gives a much more measured view. Originated by Ben Graham and popular in the blogosphere it’s an excellent part of the value investors toolkit. You can read more about the PE Ratio here.
The trouble though with the P/E ratio in general is that it doesn’t take a company’s debt into account and, in a value investing situation, that’s a pretty serious shortcoming which makes comparing differently leveraged companies like-for-like almost impossible. This is where the so called earnings yield comes in…
3. The Earnings Yield (or EBIT / EV) – buy earnings on the cheap
Investors have a tendency to switch off when faced with tricky jargon. So if you’ve made it to this sentence you are doing pretty well. Most investors define the Earnings Yield to be the inverse of the P/E ratio (or E/P) and consider it a great improvement. Why? Because yields can be compared with other investments more easily – for example bonds and savings accounts – whereas P/E ratios are, well, sort of useless for comparing against well, anything… other than other P/E ratios of course. This is most probably why brokers and the media love PE Ratios so much as they are infinitely flexible for ramping stocks up to silly valuations.
But, given that the P/E (and thus E/P) ignores debt – Joel Greenblatt in the “Little Book that Beats the Market” redefined it to take the debt into account. His definition compares the earnings due to all stakeholders in the firm (the operating profit) to the entire value of capital invested in the firm (i.e. the debt + the equity or ‘enterprise value’).
Just be aware that the earnings yield defined this way is a far better version of the P/E ratio for comparing how cheap differently leveraged stocks are to other stocks and that it’s definitely the right way up for comparing stocks with bonds (which is what a lot of Value Investors like to do).
4. Price to Cashflow – a good catch all?
The price to free cash flow ratio compares a company’s current share price to its per-share free cashflow. Free cashflow is defined as cash that the operation creates minus any capital expenditure to keep it running. It’s the amount of cash left over which a company can use to pay down debt, distribute as dividends, or reinvest to grow the business.
The benefits of looking at the price to cashflow versus other ratios like P/E or P/B Ratios are several – firstly some companies systematically understate their assets or earnings which can make them harder to isolate with a low P/E or low P/B scan – but secondly earnings and assets can be manipulated by crafty management accountants to make companies appear more profitable or asset rich than they actually are. In Josef Lakonishok’s studies he showed that the return profile of using the P/CF ratio is very similar to the P/B and P/E ratio – cheap P/CF stocks massively outperform high P/CF stocks in almost all timeframes – making it imperative to hunt for low P/CF stocks.
5. No earnings? Buy sales on the cheap
But what do you turn to when a stock doesn’t have any earnings and therefore no PE ratio? While earnings can vary from year to year, sales are much more stable and as a result one of the more popular approaches is to look at a stock’s Price to Sales Ratio.
The ratio was first popularised in the 1980s by Kenneth Fisher in the book “Super Stocks” and later labelled the ‘King of the Value Ratios’ by another author Jim O’Shaughnessy in “What Works on Wall Street”. But it really got a bad name when it was misused in the dotcom bubble to justify nosebleed valuations.
But it does remain a key indicator for isolating potential turnaround stocks. Low Price to Sales Ratio stocks, especially compared against their sector, can often be stocks that bounce back very quickly as they return to profitability. Look out for Stocks with historically reasonable margins trading on P/S ratios of less than 0.75 without much debt.
6. PEG Ratio – Buy earnings growth on the cheap
Popularised by ex-Fidelity star fund manager Peter Lynch and later given a twist by UK investment guru Jim Slater, the price-to- earnings growth ratio, or the PEG, takes the PE Ratio and puts it on steroids. The trouble with the PE Ratio is it is so variable depending on the growth rate of the company. By dividing the PE Ratio by the forecast EPS growth rate an investor can compare the relative valuation of each more comfortably.
It is generally accepted that a PEG ratio of under 0.75 signifies growth at a reasonable price (e.g. PE ratio 20 for EPS growth of 20%) – though be aware that when market valuations fall below average this barometer should be reduced. While the PEG tends to focus on the growth prospects of a stock, which aren’t necessarily vital to a value hunter, it nevertheless gives improved depth to the more simplistic PE for investors that like a bit more bang for their buck. You can read more about the PEG Ratio here.
Horses for courses…
The choice of which of these valuation ratios you will prefer to use will come down to the situation at hand. Some companies are consistently profitable (use P/E or Earnings Yield), some have more consistent cashflow than profits (use P/CF or EV/EBITDA), some are losing money on their sales (use P/S), others have no sales to speak of but do have hard assets (use P/B), others are a bit pricier but are cheap for their growth (use PEG). By understanding this array of value factors you’ll be far better placed to turn over different stones when circumstances favour it. Don’t be a one trick pony!
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