Welcome to this week’s edition of Stock Market Saturdays (SMS). Today, I want to talk about value investing. The thinking behind value investing is just what it seems on the surface – buy stocks that are undervalued, so that when their true value is realized the price will increase and you’ll make a profit.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
– Warren Buffett
Warren Buffett is one of the most renowned investors around, and most of his investments are based on fundamental value investing principles. So, how do you identify whether a stock is a “good value” or if it’s just a low price because it’s junk?
Which Stocks Should You Look At?
Buy What You Buy
You as a person – a buyer and consumer of the things companies in the stock market sell – have keen insight into the goings-on in the world. Don’t think for a second that you don’t. Understanding what’s trending, popular or going-to-be-huge in the coming years is an unmatched asset in the investing world.
Now, this doesn’t mean that you should chase after every newfangled idea that gets thrown on television. Far from it. You should be relentlessly choosy in the companies you choose to investigate further, and you should choose them because you believe in the company on a personal level. If you’re committed to the product, chances are other people are too and that more people will continue to buy the product in the future.
Don’t Follow the Mainstream
With that “buy what you buy” mantra in mind, you should also look to companies that are not mega-companies. Walmart, Target, Amazon, Google, Microsoft, Apple, General Electric – these are giants in their industry. Everyone knows about them. Everyone. Smaller companies have an advantage for value investors, because mainstream media doesn’t promote them as often and not as many people know about them. Because of this, smaller companies are more likely to be undervalued.
How to Determine Good Value
Don’t Trust Your Gut
Just because you like a company, doesn’t make it a good value. There are several ways you can look at a company to determine its health and whether it’s a good value. Here are some of the common indicators:
P/E and PEG
P/E and PEG ratios are very standard ways to start the value screening process. P/E ratio is Price divided by Earnings (per share). This compares the current share price to the earnings to see if the price is a good value. Lower P/E ratios are better than higher ones. However, keep in mind that P/E ratios can vary greatly among different industries, so by setting a P/E filter too low you could be missing out on some good value stocks.
PEG is really P/E/G. Price, divided by earnings, divided by earnings per share growth. It’s comparing the price to the company’s earnings still, but is accounting for the growth. Where a low P/E ratio may make a stock look like a suitable candidate, PEG can show you something different. PEG tends to be more reliable, and is better for looking across multiple industries. Lower is better, PEG should usually be less than one to be considered a value stock.
The major flaw in PEG ratios are that they account for growth, without accounting for dividends. If you really want to tell if the stock is a good value, you should calculate it as Price / earnings per share / (earnings per share growth + dividend) so you’re not handicapping stocks who offer dividends. Additionally, PEG ratio either uses earnings per share data from the past (trailing PEG) or forecasts it for the future (forward PEG). Both of these methods have flaws, it’s best to look at both when investing to compare them.
Debt to Equity Ratio
I’m more strict in my recommendation with this than most value investors. I don’t like debt in my personal life and I don’t much care for it in the businesses I invest in, either. Debt to equity ratio takes the company’s total debt and divides it by the shareholder’s equity. I prefer a debt to equity ratio of 0.4 or less, meaning that the company’s debt is 40% or less than its total equity.
Free Cash Flow
With P/E and PEG, we analyzed value based on earnings. We also need to look at free cash flow, which tells us how much money the company actual has in the bank (in simple terms). A good rule of thumb is to look for positive cash flow when hunting for good value propositions.
Summing Up Value Analysis
These are just a couple of the ways you can start to think about value investing. Smaller companies with a good value have proved to outperform the rest of the market over time. Value investing is about holding long term, and not caring about whether it’s “the right time” to buy. Care about the companies you invest over when you’re buying a stock or at what price. Invest because you love the company and they are a good value according to the guidelines above.