Value Investing

In this blog article, I am going to talk about what is Value Investing & the metrics one needs to consider to pick up the value stocks.

What is Value Investing?

Value investing is an investment strategy that involves picking the stocks that appear to be trading for less than their intrinsic value. This strategy was made famous by iconic investors like Benjamin Graham and Warren Buffett.

Value stocks are the stocks that are undervalued, i.e. traded at a price lower than their true value, making them an attractive investment option for investors. Value Investing, according to me, is kind of like looking for a buried treasure.

The following metrics one needs to consider to pick up the Value stocks -

1. Price-to-Earnings (P/E) Ratio:

The price to earnings (P/E) ratio is the most widely used investing metric in the investment world.

Price-to-Earnings Ratio = Stock Price / Total Earnings (EPS)

The P/E metric is a popular one because it establishes a relationship between a stock’s price and a company’s total earnings, giving a clear indication of whether it is an undervalued stock or not. A high P/E ratio could mean that a stock's price is expensive relative to earnings and possibly overvalued. Conversely, a low P/E ratio might indicate that the current stock price is cheap relative to earnings.

What is the good P/E ratio to consider? Well, it depends upon the sector or industry the company is in, the phase (early growth vs. stabilisation) of the company etc. For example, a P/E ratio of 10 could be normal for the utilities sector, even though it may be extremely low for a company in the tech sector. Because of this, it’s important to always compare P/E ratios with other companies within the same industry. I would say that a 20-25 P/E ratio is a normal ratio and more than 30 is a bad one.

2. Price-to-Book (P/B) Ratio:

Another popular investing metric is the price to book (P/B) ratio. The P/B metric establishes a relationship between the stock’s price and its book value. It is also a very efficient way of determining whether a stock is undervalued or overvalued.

Price-to-Book Ratio = Stock Price / Book Value

The book value of a company is determined by subtracting its total liabilities from its total assets. 

Example - Assume that a company A has $50 million in assets on the balance sheet, and $20 million in liabilities. Therefore, the book value of that company would be calculated as $30 million ($50 million - $20 million).  If there are 3 million shares outstanding, each share would represent $10.00 (30/3) of book value. Therefore, if the share price is $8, the P/B ratio would be .8 (8 /10).

The reason the ratio is important to value investors is that it shows the difference between the market value of a company's stock and its book value. The market value is the price investors are willing to pay for the stock based on expected future earnings

A P/B ratio of 0.95, 1, or 1.1 means the underlying stock is trading at nearly book value. To a value-seeking investor, a company that trades for a P/B ratio of 0.5 is attractive because it implies that the market value is one-half of the company's stated book value.

3. Debt-to-Equity Ratio:

The debt-to-equity ratio (D/E) is a stock metric that helps investors determine how a company finances its assets. The ratio shows the proportion of equity to debt a company is using to finance its assets.

A low debt-to-equity ratio means the company uses a lower amount of debt for financing versus shareholder equity. A high debt-equity ratio means the company derives more of its financing from debt relative to equity. Too much debt can pose a risk to a company if they don't have the earnings or cash flow to meet its debt obligations.

​​Generally, a good debt ratio for a business is around 1 to 1.5. However, the debt-to-equity ratio can vary significantly based on the business's growth stage and industry sector. For a mature company, a high D/E ratio can be a sign of trouble that the firm will not be able to service its debts and can eventually lead to a credit event such as default. For a growing company, a high D/E could be a healthy sign of expansion. In all cases, D/E ratios should be considered relative to a company's industry and growth stage.

4. Free Cash Flow:

Free cash flow (FCF) is the cash produced by a company through its operations, minus the cost of expenditures. In other words, free cash flow is the cash left over after a company pays for its operating expenses and capital expenditures(CapEx).

Free cash flow shows how efficient a company is at generating cash and is an important metric in determining whether a company has sufficient cash, after funding operations and capital expenditures, to reward shareholders through dividends and share buybacks.

Free cash flow can be an early indicator to value investors that earnings may increase in the future since increasing free cash flow typically precedes increased earnings. If a company has rising FCF, it could be due to revenue and sales growth or cost reductions. In other words, rising free cash flows could reward investors in the future, which is why many investors cherish free cash flow as a measure of value. When a company's share price is low and free cash flow is on the rise, the odds are good that earnings and the value of the shares will soon be heading up.