4 Useful Value Investing Measures

"[A cynic] knows the price of everything but the value of nothing" - Oscar Wilde

Value investing can be seen as a technique of buying good companies at a price that is less than their intrinsic or relative worth. It is this investment strategy that has made investors like Benjamin Graham, and his mentee Warren Buffett, incredibly wealthy.

The general concept of value investing is that you are looking at measures of a company's underlying business success and not just its share price.

Value investing is often compared to, and seen as the opposite of, growth investing. It is in this author's view that this may be false, because it is possible to value a high growth company. Value investing does not preclude investing in a high growth company but rather requires factoring in the uncertainties of growth forecasts into the value calculations and comparing that value against other companies in the same sector. In his book titled 'The Little Book of Valuation', Aswath Damodoran explains techniques of valuing growth companies that are similar to valuing established companies.

This article is not going to focus on valuing growth stocks, however, as that is much more complex and relies on forecasting (which can be inaccurate and difficult to calculate). Rather this article will focus on how to find stocks in companies that are trading below their real value based on known data.

Price to Earnings Ratio (P/E Ratio)

The price to earnings measure is a ratio of a company's market price per share to its earnings per share. P/E indicates how much you are paying per share for the earnings per share.

The P/E ratio helps you compare are company to similar companies in the same sector. For example, if company 'A' has a P/E ratio of 15 and the median of other companies in the same sector is 25 then you may consider company 'A' to be selling at a discount.

NOTE: it is useful to use the median instead of the mean (average) as the mean can be skewed higher due to outliers, especially in the technology sector where at the extreme we get companies with P/E ratios in triple digits.

Time to payback - another way to look at the P/E ratio is it indicates the number of years, at the current earnings and price, it will take for the earnings to pay for the share itself. So if company 'A' has a P/E ratio of 15, it will take 15 years of earnings for the earnings to pay for the share price.

Low P/E ratio - can indicate that the market does not value the company's future growth potential, or future earnings, very highly. e.g. Company 'A' makes widgets that service the population and is currently profitable, but a new technology is emerging which means the future sales of those widgets may fall.

High P/E ratio - can indicate that although the current earnings per share are low compared to its price the market thinks future earnings will be much greater (i.e. there is high growth potential). Technology stocks have a notoriously high P/E ratio compared to other industries. e.g. The average P/E ratio in the technology sector (software Internet) is approximately 83 compared to air transport at 7.5. Source.

Trailing vs Forward P/E ratio - trailing P/E ratio takes the current share price divided by the average earnings over the last 12 months. Often denoted as TTM (Trailing Twelve Months). The Forward P/E ratio uses the projected, or forecasted, earnings for the next 12 months.

NOTE: the Forward P/E ratio relies on analysts expectations of earnings which can be inaccurate, you may want to value its results with caution (source).

Price to Book Ratio (P/B ratio)

The price to book ratio is a measure of a companies stock price to its net value (assets - liabilities). This is a very conservative measure as the book value only considers total assets minus intangible assets. Intangible assets include such things as licenses, trademarks, patents, copyrights etc.

The lower the better

A ratio of 1:1 (or a price to book of 1) indicates that the share price and the book value match. Therefore, a P/B ratio of less than 1 indicates that the shares of a company are trading below the intrinsic value of the company. A company trading for less than its intrinsic value (P/B ratio < 1) could have its assets liquidated and still return a profit to the shareholders.

According to Aswath Damodoran, price to book ratios should have more relevance in financial service firms as their book value closely matches the real market value for their assets.

Limits of P/B ratio

As mentioned above, P/B ratio does not factor intangible assets like copyright, goodwill and intellectual property, so it is unlikely to be very useful to value technology companies like Google, Microsoft and Apple.

NOTE: A P/B ratio, like a lot of other ratios, is generally only relevant when comparing companies in the same, or similar, sectors.

Return on Invested Capital (ROIC)

Return on invested capital is a measure which looks at the profit a company is making on the money from shareholders and debtors. This is a useful measure because it shows us how good the company is at turning a profit. The value is expressed as a percentage which enables a fair comparison to other companies as well as comparison against inflation and government bonds.

ROIC should be compared to a company's weighted average cost of capital (WACC). The WACC is the cost of the capital, for example, if a company sourced its capital by issuing bonds with a yield of 10%, then the cost of capital is 10%. If the ROIC is greater than the WACC then the company can be considered to be returning value on its WACC. The higher the ROIC - WACC the better.

As an overview, the ROIC can be calculated as below:

Click here for a detailed example of how to calculate ROIC on a real company.

Net income: can be calculated by getting the sales income minus operating costs. Calculating net income is not trivial and requires further in-depth explanation which is beyond the scope of this article.

Invested capital: is stocks or bonds issued by the company.

Weighted average cost of capital

The WACC is a good measure of how much it costs a company to source its capital which it then uses to invest in operations and development. WACC is calculated using the formula below:

• E = market value of equity.
• D = market value of debt
• V = E + D
• Re = cost of equity
• Rd = cost of debt
• Tc = corporate tax rate

For a more detailed look at WACC take a look at our worked example and explanation of WACC here.

What is a good ROIC?

To determine whether a company has a good ROIC it should be compared to its WACC and the average of the rest of its sector. For example, if company 'A' had a ROIC of 10% and it's WACC was 4% it had an adjusted return of 6%. Compare this value to the rest of the sector to give perspective.

Free Cash Flow (FCF)

Free cash flow is the amount of cash flow left over after all operating expenditure is covered. Having a large free cash flow is positive because it can be distributed to share-holders, creditors or re-invested to improve future earnings. In its most basic form FCF can be calculated using the following equation:

FCF = operating cash flow - capital expenditures

It is useful to measure FCF over time to see whether it is trending up or down. A FCF that is increasing over time hints to the increasing profitability of a company's operations. A falling FCF may not be an indicator of poor performance but as a consequence of a higher reinvestment on new equipment. Because of this there are further methods outlined below that factor in depreciation which helps flatten out the FCF curve over time.

FCF has related measures such as free cash flow to firm and free cash flow to equity.

Free cash flow to equity (FCFE) factors in depreciation. There also seems to be various different ways to arrive at FCFE, which is confusing (for the reader and author). A common formula for calculating FCFE uses the equation below:

Free cash flow to firm (FCFF) on the other hand is the cash left over after all taxes and reinvestment needs, but before interest and repayments on debt have been made. For FCFF we use operating income instead of net income and subtract taxes and reinvestment costs.

Finishing Up

Intrinsic value is measured by the cash flows that a company is generating now and into the future. Relative valuation is the process of taking a company's intrinsic value and measuring it against other companies in the same sector.

The measures above give both intrinsic and relative values for a company. By using these measures you can create a narrow list of companies that you can then investigate further.

Exercise

Filter companies with a P/E ratio of less than 15, with a P/B ratio of less than 1. Only look at companies in the same sector. Once you have a small enough list examine the difference in ROIC and WACC compared to the other companies. Then look at the FCF over time to see how each company is performing intrinsically and relatively to the other.

Select the best performing companies and watch your selections over time.

Notes

DISCLAIMER: the discussion of these valuation methods should not be taken as indicating buy or sell signals. Rather these valuation methods can be used to help narrow down the selection of companies on an exchange that warrant further investigation.

Average values: Valuation ratios can be skewed by outliers to such a degree that an average (mean) across the sector will be distorted high. Because of this, it may be better to use the median value instead.

Excluding companies: some value investing measures may not give an accurate measure due to a large proportion of businesses being removed from the total pool. Take for example P/E ratios; if companies with negative income, and therefore negative P/Es, are removed from the measure this will bias the results. So be skeptical of any measure that removes a large portion of companies from the pool.

Historical comparison: comparing current ratios, like P/E, to historical ratios can be very misleading as interest and inflation rates may have been very different in the past. Therefore, you are less likely to be making a fair comparison.