Investors generally categorize stocks into two groupings – growth stocks and value stocks. Both types of stocks have their own characteristics and investors use different approaches to find and identify companies that fit into one of those two categories.
One of the most important things to understand as a value investor is the fact that there is a clear difference between the price of a stock and its underlying value.
“Price is what you pay. Value is what you get.”
The stock price is what people are currently willing to pay for a share of a company, while the value is what really lies within the business. Only because stock prices can heavily deviate from their fundamental values, investors are enabled to overpay or underpay for their investments.
You may have already heard of the simple principle of successful investing. Buy low and sell high. This rule seems so straightforward, yet it is so hard for many investors to accomplish.
Most investors can’t even follow the rule, simply because they don’t really ask themselves the real question. What’s low and what’s high?
And this where value stocks come into place. Because those are the stocks that are supposed to be bought low (when they’re undervalued) and avoided when they’re high (overvalued).
In the following, we will go through the main characteristics that make up a typical value stock.
What are Value Stocks?
By definition, value stocks are companies that trade for a lower price relative to their fundamental values. Investors who actively look for companies that trade at a discount of their real value (also called intrinsic value) are called value investors.
Identifying a value stock is easy, but evaluating if a company is undervalued, overvalued, or fairly priced is the more difficult part. Common characteristics of value stocks include a high dividend yield, a low P/E, P/B ratio and PEG ratio, a long and consistent history, and a healthy amount of debt.
Value investors use multiple methods that differ from each other in terms of complexity. More advanced investors may use a discounted cash flow model (DCF) to determine the intrinsic value of a stock, while others rely on different valuation metrics in comparison with historical values to get a better view of a stock’s value.
Oftentimes, companies present themselves as value opportunities when they become unfavored by the market for a specific reason, leading to a stock price decline that would drive up valuations in the view of investors.
However, the requirement for a value stock to essentially become a great investment is a change in the market’s perception. Value stocks mostly trade for great value because other investors perceive the company in a negative way. That’s why as a value investor it’s important to be right with each assumption you make.
How to Find Value Stocks
The most common way to quickly identify a value stock is to analyze a company using different financial metrics and valuation multiples that are supposed to show the relation between a company’s stock price and its underlying fundamentals. Here are some of the most important metrics, which every investor should know:
The most well-known multiple is the price-to-earnings ratio (P/E ratio). It can be calculated by dividing the current price of a stock by the earnings per share (EPS) of the company. The lower the P/E ratio of a stock, the more undervalued the stock may appear.
A price-to-earnings ratio of 1 would mean that the company is currently trading for the exact amount of earnings, while a P/E of 15 tells that the stock is trading for 15 times its earnings. Another way in which you could look at the P/E is this: For every 15 dollars you pay, you would receive 1 dollar as earnings out of the company.
In most cases, you don’t have to calculate the price-to-earnings ratio for yourself. Nearly all financial research sites and platforms already state the current P/E ratio of a company within its financial information section:
Source: Yahoo Finance
P/E ratios of different companies can vary from each other, depending on the type of business and the industry in which it operates. Mature companies that are operating within industries that aren’t expected to grow rapidly in the future generally have a lower P/E than companies that operate in younger and fast-growing industries.
This is why a lower P/E isn’t necessarily enough to justify a good investment. For instance, as of the second quarter of 2020, PepsiCo (PEP) is trading at a P/E of 25, while Netflix (NFLX) currently trades at a P/E of 84. Both companies are well-known but it would be hard to tell immediately which stock would be the better investment, even if from a price-to-earnings perspective, Netflix seems four times more overvalued than PepsiCo.
Based on the very high P/E nature of Netflix, many investors would consider it a growth stock, while PepsiCo may rather be viewed as a value stock.
As a result, it would make much more sense to compare the P/E ratio of a company with its own historical values in order to identify its current value standpoint:
As you can see in the chart, the P/E ratio of Apple (APPL) has fluctuated quite often due to heavy price movements as a result of lots of speculation and popularity amongst investors.
However, the earnings-per-share (EPS) was growing at a stable rate during the same period. If you were interested in the company, it would have been a good time to buy when the P/E was at its low in early 2019. But you wouldn’t have had any clue by just looking at the price of the stock. You can only get a better sense of the stock price when you put it into comparison with fundamental values.
The price-to-book ratio (P/B ratio) is similar to the P/E ratio but compares the current stock price with the book value of a company. Book value is defined as the difference between a company’s total assets and total liabilities.
The book value can also be referred to as the shareholder’s equity which is stated at the bottom of a balance sheet. On a per-share basis, book value is calculated by dividing the total equity by the number of outstanding shares.
Book value is important because it represents the raw value of a company. If the company had to liquidate its assets and pay back its liabilities, all that would be left is book value.
Most companies trade at a price-to-book ratio above 1.0, meaning that the current stock price exceeds the book value of a company, which is completely reasonable since book value alone can’t fully account for the value of a business.
That being said, typical value stocks trade at a low price-to-book ratio, preferably even below 1, meaning that you would essentially underpay for the book value of a company.
A price-to-book ratio below 1 can be a strong indicator that the company is undervalued, however, it could also mean that something is fundamentally wrong within the business that leads investors to push down the price.
Generally, it can be said that the lower the P/B ratio of a stock the more undervalued it might be but similar to the P/E ratio, you should also put the company’s P/B ratio into perspective with historical values and industry standards.
The dividend yield shows the amounts of dividends you would get annually from the company expressed as a percentage rate. Just like the other valuation metrics, the dividend yield puts the current stock price and the dividend into comparison. The higher the dividend yield, the less you pay for more dividends out of the company.
For example, let’s assume that you buy a share of stock for $40. The stock pays dividends on a quarterly basis, meaning that you would receive a dividend four times a year.
Every quarter the company pays out a dividend of $0.50 per share. That would make up a dividend of $2 annually. In order to calculate the dividend yield, you divide $2 by the stock price of $40, and you would come up with a percentage of 5%.
A dividend yield of 5% is actually really good. Only a small number of companies pay such a high dividend. However, a higher dividend yield doesn’t necessarily mean that the stock would be a good investment.
A company is never required to pay dividends at any given time, so businesses might decide to suddenly cut the dividend when they think that it’s necessary.
This is why good value stocks should have a consistent history of increasing dividends in addition to a high dividend yield. A stock that only shows a high dividend yield at the current time but isn’t able to pay that dividend consistently in the long run, may not be a good value investment.
In the traditional view, value stocks are supposed to be stable and mature companies with good financial health that trade at P/E ratios under 15, P/B ratios under 1.5, and high dividend yields.
Investing only based on those criteria may have brought good returns in the past. However, times have changed and just buying random stocks at certain multiples may not be enough anymore. Many value investors might as well buy growth stocks as long as they trade at reasonable prices.
That’s why it makes more sense to use valuation metrics in order to evaluate the current standpoint of a stock’s value, instead of just investing in value stocks without any further analysis.