Value Investing: 5 Things To Look Out For In A Company
Benjamin Graham, the “father” of value investing and one of the best investors of all time once said,
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
Cheem right? What did he really mean?
Well… allow me to introduce you to the concept of Value Investing. And perhaps after reading this, you’ll be able to figure it out.
What is Value Investing?
Firstly, there are two types of investors:
- Short-term Investors, and
- Long-term Investors
Short-term Investors buy and sell their stocks in a short time period – which is anytime from a day to a couple of years.
Long-term Investors, on the other hand, are those who buy and hold their stocks until they appreciate in value. And this practice usually involves a longer time horizon.
Secondly, some people prefer investing in bigger blue-chip stocks, which are generally less volatile.
While others choose to dabble in smaller cap stocks in hopes that they will appreciate in value.
So what’s value investing got to do with all of this?
Value Investing is the process of finding underpriced stocks, buying them, and holding them for the long-term until the market sees the value in the company and what it does.
Such stocks are usually smaller companies as they have a greater potential to see a large increase in their share prices.
So… How do we find good value stocks? Here are five things you can look at.
1. Valuation Metrics
Usually, value stocks are traded at cheap prices. The first step is to filter out stocks which have low P/E and P/B ratios.
Looking at the formulas for these financial ratios, cheap share prices would naturally drive down the price ratios.
Compare the P/E ratio with industry peers. The more well-known companies are expected to have a higher P/E ratio. What you want to look for, rather, is the smaller companies with a low P/E ratio as this means their market price is cheap.
Find a stock with a P/B ratio that is less than 1. This means that it is currently priced cheaper than its equity or book value.
Price-to-Earnings Growth (PEG) = P/E ratio / Earnings Per Share Growth
Price-Earnings Growth is another financial metric to look at. It takes into account the earnings growth, which looks more into future growth vis-à-vis P/E ratio which is based on historical figures.
2. Intrinsic Value
One technique that Benjamin Graham uses is finding the net-net value of the company, which is by valuing the company using its current assets
Net-Net Value = Current Assets – Total Liabilities
If the current assets can cover all of the company’s liabilities, the net-net value will be positive and that will be an investment worth looking at.
Of course, as with all formulas, there are limitations. Taking the net current assets does not give you the full picture. Certain industries by nature hold large amounts of their assets in the form of non-current assets eg. property and technology.
It can also be harder in the present times to find a stock that has current assets exceeding total liabilities, compared to in the past. In the past, there is a higher tendency for companies to hold on to cash and there were fewer investment options in the market.
3. Debt-to-Equity Ratio
The company could be doing well, or be paying out high dividends which is largely financed by debts.
Financial leverage is the percentage of financing in terms of using debts vs. equity. Generally, a company with higher debt-to-equity ratios is more dangerous as profits made on borrowed funds need to be greater than the interest on the debt. There are also concerns about their ability to repay debts on time.
That being said, a company with high debt is not necessarily bad, if the company’s ability to make profits is high. But overall, stocks with higher debt-to-equity ratios are generally more volatile and you should find a company with a low debt-to-equity ratio.
4. Price-to-Free Cash Flow
A company’s free cash flows represent the cash flow available for all the stakeholders.
Cash is the most liquid current asset the company can have. Cash is generally always good and you should want to see high cash flows in the company. (There is a whole argument on why too much cash is bad, but that’s for another time…)
Price-to-FCF Ratio = Price / Free cash flow per share
Lower numbers indicate that a company is underpriced.
5. Company Fundamentals
Note that not all stocks that check the aforementioned criteria will be GOOD value stocks.
Sometimes, stocks are cheap for a reason.
A stock could be trading at a cheap market price because investors do not see a good future in it. And this could be due to news like poor management or declining industry etc.
What you can do, is to research on the company by:
- Reading the Financial Statements
- Finding out what it does
- Understanding the industry – is it cheap because it is in a declining industry?
- Identifying the potential challenges the company might be facing
- Keeping current with news about the company
You may want to check out: Is Duty Free International Limited (SGX: 5OS) in a declining industry?
Hopefully, the company that you choose to invest in pays a good dividend.
A small company may not have a fixed dividend policy, so that is something you should take note. You can check their historical payouts for reference. Think of dividends as the company’s way of rewarding you, the investor, for putting your money in them!
Value Investing is (usually) investing in the long-term and picking stocks that are trading at a market value that is less than their intrinsic value. Then, you wait for the stocks to appreciate in value.
Value Investing is more for risk-loving investors, rather than those looking for stability. This is because, for such companies, it is common that share prices can fluctuate wildly or may not even move at the start.
If this looks like you when your portfolio goes down… You may want to think twice and take greater caution because small companies can be very risky.
In the short-term, the market may not see the value in that company, because, like the quote above, the market is a voting machine in the short run. It is dependent on market psychology.
What a value investor wants, rather, is to hold the shares until one day, the market value rises to its intrinsic value.