Spotting good value opportunities in equities
The conventional wisdom is to buy “undervalued’ stocks and let time do its job of building value. But how do you spot an undervalued stock? Buying “cheap” is not the same as buying “value”. There is “good and cheap” – never easy to find. And then there is just cheap. Here are 3 insights to begin with. (Note we use the terms stocks, shares and equities interchangeably.)
1: “Value” is inseparable from “quality”
In seeking genuine value, start with a series of questions towards identifying the hallmarks of quality.
- Is the company profitable and is it likely to continue to be profitable into the future?
- To determine whether you have the “time” needed to unlock value, investigate whether the company is operating in a growing or at least stable industry? Or is it in a declining industry?
- In determining the company’s ability to prosper into the future, you need to understand its competitive environment. Does the business have low or high barriers to entry – such as licensing, regulatory barriers or unique technologies/capabilities? Or can competitors easily copy its products or business model?
- Is the company’s management reputable and capable?
- Look at the company’s Profit and Loss Statement over recent years – has it been maintaining or growing earnings? Has its operating profit margin (operating profit as a percentage of sales/revenue) been growing, stable, or declining?
- Is its balance sheet sound? That is, does it have too much debt relative to shareholders funds? So, look at indicators such as the debt to equity ratio (equity on the balance sheet is defined as total assets minus total external liabilities), the current ratio, and the liquid ratio.
Although debt to equity ratios vary depending on the industry, a rough rule of thumb is you should be a bit wary if it is over 1.5 and you would want to ask some hard questions if a company has a debt to equity ratio over 2. The current ratio is the current assets divided by current liabilities. Anything below 1 warrants a very careful investigation. The higher the figure above 1, the more comfortable the company will be in meeting short-term liabilities. Then there is a tougher test called the Liquid Ratio or Acid Test Ratio. It is the current assets minus inventory, divided by current liabilities. In other words, it tests a company’s ability to meet short-term liabilities without having to depend on selling inventory. Again, anything below 1 warrants a good hard look.
- Look at the cash flows as well. Companies can be generating apparently good “accounting profits” but be considerably weaker in cash flow terms. In an extreme, a company can get into financial trouble even if it is reporting accounting profits but not generating enough cash flow to meet commitments. In another scenario, a profitable company might be burning up so much cash in expansion/investment that it has very little cash left over to distribute to shareholders. That’s where dividends come in – the better the dividend payout, the more able you will be to withstand market down cycles. That is, you get paid while you wait.
2: Relative valuation – a way to understand how much you’re paying for a stock compared to that of a similar company
Compare valuation ratios with similar companies across the industry. The two most commonly used valuation ratios are the Price to Earnings Ratio (PE Ratio) and the Price to Book (PB Ratio). These are known as “relative valuation” ratios.
The PE ratio is the price of a stock divided by either the forecast coming year earnings per share (prospective PE) or the immediate past year’s earnings per share (historic PE). So, if you’re using the price to historic earnings, then compare the company’s historic PE with those of similar companies in the same industry. Generally, the lower the better.
The Price to Book ratio (PB Ratio) is the price of the stock divided by the company’s book value per share. The book value is the net asset value of the company.
Again, the PB ratio one should pay is relative. It is relative to the industry and comparable companies. It is easy and common to say “lower is better”. But we go full circle here – back to the starting point about good value versus just cheap.
3. Beware unusually cheap stocks and do not necessarily shun relatively high pe stocks
If a stock is trading at a PE ratio or PB ratio very much below its industry average, you have to ask “why”? If most of the industry is trading at low valuations, there could be industry-wide, cyclical reasons, which could pass. But if it is unique to one company, there could be structural factors which could bring the stock price down even further.
For example, during a down-cycle for a particular industry – say, the property industry – you can often see property development companies and real estate investment trusts trading below book value. But this should be a sector-wide phenomenon. And this is where judgment comes into play, if your view is that the property market cycle will pass, that’s a value buying opportunity.
But if there are no obvious cyclical factors at work, be very careful that there are no structural factors particular to the company you’re looking at. That is, the cheap valuation relative to historic earnings or book value per share could be a reflection of the market’s expectation that either earnings and/or book value are about to collapse.
Conversely, if a stock has an above industry average PE, you should check if there are quality factors that justify paying that higher valuation. One way is to compare the PE against forecast earnings per share. That is, the PE to growth (PEG) ratio. Even if a stock trades at a higher than average PE, it may not be expensive if its PEG is lower than the industry average. That is, the higher PE Ratio reflects a higher earnings growth rate.
You can also look at the returns on equity (ROE) of the stock. If it has a higher earnings per share relative to net asset per share than its industry peers, that could justify paying the price.
There are many other things we can talk about in understanding how to buy “good and cheap”. And this is by no means an exhaustive “teach-in” on the subject. But we hope it helps you to ask the right questions and starts you on your investment journey.
Ready to start?
Speak to the Wealth Planning Manager today for a financial health check and how you can better plan your finances.