Value Investing: Finding Your Winner
Last week, we talked about three investing styles: growth, income, and value.
And it's safe to say that over the long run, value investing came out as the best bet.
Today, we're going to go over the process of how to pick your own value stocks. There are only two steps...
Step 1: Build a List of Potential Winners
The first thing you'll need to do is make a list of some companies you're looking to invest in.
Each of us has our own ways of picking companies. It could be a particular sector like technology or energy, large caps versus small caps, or it could be as simple as a company with products that you use.
It doesn't matter how you select them because your goal here is to compile a list with as many companies as possible to research. In the following step, many of your listed picks will be disqualified as undervalued. And that will leave your list of winners shorter.
If you can't think of any companies for your list, try to recall some that are familiar to you. Whether it's from what you hear on CNBC or read in the papers, there's a ton out there...
Step 2: Screen Your List
Your next step is to screen the companies on your list against a series of variables. These variables will help determine if they're undervalued or just an unattractive stock.
One thing to look at is whether or not the company pays a dividend. An important aspect of value investing is to have the patience for your potential winners to reach their intrinsic values.
That could take years to happen. But the dividend payments will give you instant gratification while your stock appreciates. It's a win-win situation.
The company that you're evaluating should have free cash flow. Free cash flow is the money a company has after all its expenses have been paid. It's important to see what management does with that extra cash. It should be used for expansion, to develop new products and services, and even to keep shareholders happy with dividend payments.
Second, the company should meet or exceed earnings expectations.
A high-earning yield tells you that the company is generating a lot of profit with its current share price.
The company should have an earnings growth of at least 7%. Additionally, it should have experienced consistent growth over time, with no dips more than 5% over a decade's time.
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But a value stock isn't only defined by its dividends, free cash flow, and earnings. The following are other crucial factors for identifying a value stock...
- Share Price vs. Intrinsic Value: If the company's current share price is under its estimated intrinsic value, it could be a value stock. The share price should be no more than two-thirds of the company's intrinsic value.
- Price-to-Book Ratio (P/B): A company's price-to-book ratio is important to identify if a company is undervalued. A P/B reflects a veiled, valuable side of the company that investors are unaware of, which results in its undervaluation.
You can find a company's P/B by dividing its current share price by the book value per share (BVPS) from its most recent quarterly reports.
You, the value investor, are looking for a low P/B, especially if it's lower than others in the company's industry. You should also be interested in a company's P/B if it's lower than the recent quarter's book value.
- Price-Earnings Ratio (P/E): A low price-earnings ratio is important for your value stocks. A P/E ratio tells you how much a company's share price is with its earnings per share (EPS).
You should look for companies with P/E ratios under 40%.
- Price/Earnings-to-Growth Ratio (PEG): A company's price/earnings-to-growth ratio tells you how much the company has grown over time. You can get this ratio by dividing the company's P/E ratio by its earnings over time.
The lower the PEG, the better. It means that you bought shares for a steal, compared to the growth it's had over time.
- Debt and Equity: The company should have low debt. Its debt-to-equity ratio (D/E) explains how much the company is using debt or equity to finance itself.
A lower D/E tells you that the company doesn't use much debt compared to its equity for financing. This is good for you, a value investor.
A higher D/E could show that the company used more of its debt than its equity for financing. The risk that comes with a high D/E is that one day, the company's debt could cost more than it can handle. And that could cause plenty of problems that would spell a loss for you.
And there you have it. With all this in mind, you should have no trouble locating your winning value stocks. It may seem challenging but stick with it. Nothing great is acquired without the hard work spent to earn it.
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John Butler Jr.
Contributing Editor, Park Avenue Digest