Value investing is Warren Buffett’s bread and butter. He identifies “cheap” companies relative to its intrinsic value and purchases them. In this post I’d like to show you the steps I take to identify what value stocks are.
Why Value Investing?
Value stocks are generally referred to as stocks that are cheap and on sale compared to its actual value. Warren Buffett has been known to identify companies he believes are cheap and invests in them. Benjamin Graham also wrote about this process in his book “The Intelligent Investor”. If you had found a new car on the market for $5000 cheaper than what the Kelley Book says, you might be interested in purchasing it.
In Warren Buffett‘s biography, he mentions investing in a company who’s share price does not reflect the company’s assets. Specifically, the stock price of a company was less than the actual cash the company had. It’s similar to buy a lemonade stand for $90 knowing that there’s $100 in the cash register. You’re buying a company that the market may have wrong opinions about.
The common alternative to value stocks would be growth stocks. However based on this study by Fidelity since 1990, value stocks have outperformed growth stocks by 40 basis points on an annual average over 26 years.
To identify potential value stocks, we’ll look at certain fundamental ratios: P/B, Debt-to-Equity, PEG, and ROI. To screen for these values, I use Finviz, a pretty popular free stock scanner.
Step 1: Go to the Stock Screener on Finviz.com
Located at: http://finviz.com/screener.ashx
You’ll see a screen like this:
Note: You may have to click on the “All” tab in the middle to get all of the ratio fields.
Step 2: Choose Fundamental Ratios
Going back to the ratios I mentioned earlier, I like to set the following criteria for screening:
- P/B Ratio < 1
- Debt-to-Equity < 1
- PEG Ratio < 1
- Return on Investment > 0%
These can be anything of course and don’t necessarily need to be set to these values. In fact, in a bull bubble like this it may be hard to find companies that satisfy these criteria so you may need to adjust your flexibility in order to identify good companies.
P/B Ratio compares the current market value of the company (the price you see in the stock market) versus the company’s actual book value. A low P/B ratio indicates that the market value is less than the company’s book value. In every day terms, this is parallel to buying a new car for $10,000 (The market price) when the total value of all parts in the car costs $15,000 (The book value). This is a good indicator of a company being undervalued. However it could also mean that the company may be in distress (if the total value of all parts in the car can be purchased for less than $10,000 now).
To confirm the P/B ratio, we add the Debt-to-Equity ratio in order to assist us in determining a company’s financial stress situation. A company with high debt versus equity may indicate some financial problems. Setting this criteria to under one means it has low debt relative to the company’s market value.
The PEG ratio takes the P/E ratio and compares it to the expected growth rate. A higher expected growth rate will make the PEG ratio smaller which may indicate a company being undervalued.
I like the Return on Investment number since it shows a positive return for each dollar of invested capital.
Step 3: Other Fundamental Ratios
Additional Ratios I like to add:
- Dividend Yield > 0%
- Price above 200 day moving average
- Market cap > 500m
I personally like stocks that pay dividends, as long as it’s not too high. This indicates that the company has a fairly stable net income and cash flow. Companies like NVDA and LUV with low dividend yields means it’s reinvesting most of its profits back into the company. It also means there’s a lot of room for dividend growth in the future. Dividend growth attracts more investors to the stock and drives up the price.
A price above the 200 day moving average generally indicates an overall positive trend.
I also generally look for decent size companies. Small companies will generally have more volatility and/or more in their growth stages rather than value stages.
Value Investing is Relative
Additionally, to determine whether a company is “cheap” or not, you need a yardstick from which to measure. If you go to Morningstar, under the “Valuations” tab, you can find a see how a company is doing compared to its peers using some of the ratios above. In other words, value investing is all about its relative value to its competitors. Below is a valuation of Jetblue Airways Corp as a sample:
As you can see, JetBlue’s P/E, P/B, and P/S, and P/CF are all below the industry average.
- A P/E below the industry average is a positive sign. This generally means it’s under valued.
- A P/B below the industry average is a positive sign. The book value of its assets (the denominator) is high while the stock price (the numerator) is low.
- A P/S below the industry average is a positive sign. Higher sales in the denominator coupled with a low stock price in the numerator.
- A P/CF below the industry average is also a positive sign. A high cash flow in the denominator and low stock price in the numerator.
These would be all positive signs and support an argument in value investing with JetBlue. As with anything else, do your thorough research. Just because a company shows positive signs doesn’t mean it’s shitting out rainbows and unicorns. There may be reasons for this and it’s up to you as the investor to determine why. That’s the basis of value investing.