Tools for the Value Investor

By Editorial Staff
January 21, 2010

Have you ever sat back and tried to compile a list of the most successful investors of all time? If you're like most, then during that process you probably considered such names as Warren Buffett, Benjamin Graham, and Peter Lynch.

While all of these great investors certainly had distinct approaches to the market, they did have one thing in common: They are all considered -- to one degree or another -- to be value investors.

(1.)  What is Value?

Before going any further, we first need to get a better understanding of the term "value." In order to grasp this important concept, we should take a step back and look at what we're actually buying when we purchase a stock.

Investors choose to purchase stocks for a variety of reasons. Some buy into companies that offer compelling and enticing stories -- a new blockbuster drug, an emerging technology, or an exciting new product. Meanwhile, others may seek out firms that have a dominant brand name, attractive growth prospects, or substantial underlying assets


However, when purchasing a stock, it's important to remember that you're not really buying a story, a manufacturing plant, a management team, or a bunch of equipment. At its very core, every stock investment simply involves the purchase of a stream of future cash flows.

Although this cash can sometimes come from the sale of certain assets (or the entire business itself), it primarily comes from a firm's operating activities. With this in mind, a hot momentum stock may have a great story to tell, but ultimately that story will prove meaningless if it doesn't lead to the generation of solid annual cash flows. In the end, it's cash that is needed to fund dividend payments, repurchase shares, and ultimately grow a business. 

Sure, from time to time high-flying growth companies can eventually blossom into cash-generating machines -- such as Microsoft (Nasdaq: MSFT). However, for every hot growth/momentum stock like Microsoft that matures into a highly profitable bellwether, there are countless others that fall into obscurity and deliver nothing but heartache for investors. Even worse, as we saw all too often following the dot-com boom in the late 1990s, many of these companies can even end up in bankruptcy.

Value investing isn't about purchasing stories -- it's about buying stable companies with proven business models that generate consistent annual cash flows. More importantly, value investors are, above all, price conscious -- always searching for companies that are trading for much less than what they are actually worth. In other words, value investors look for situations where the future stream of cash flows a company is likely to produce has been mispriced by the market.

Most value investors also rely on the important concept of margin of safety when evaluating potential investments. In doing so, they first use a variety of techniques to estimate the true intrinsic value of a company. They then invest exclusively in those firms that are trading at a sizable discount to their estimated intrinsic value. By investing only in firms that offer a solid margin of safety, value hunters can minimize their downside risk and usually earn above average returns on a stock -- even if they have slightly overestimated its true value. 

In many cases, this discount is the result of a short-term concern or even a misconception among the crowd. And when those fears blow over, the stock often recovers and rallies toward its true intrinsic value -- yielding huge gains to those that looked beneath the surface. To see this methodology in action, look no further than Warren Buffett -- whose track record offers myriad examples. One such situation was Buffett's 2003 purchase of Clayton Homes, a builder of manufactured homes. 

Prior to the acquisition, Buffett believed the market was undervaluing Clayton due to the volatile history of the manufactured-housing industry. During booms in the real estate market, manufactured-housing companies typically had overly aggressive lending policies. When the market slowed, these same companies would then struggle to collect on a portfolio of ill-advised loans (similar to the recent housing market crash). 

When Buffett picked up Clayton, the Fed was preparing to raise interest rates and many investors on Wall Street felt the boom-and-bust cycle was about to repeat itself again. Conventional wisdom at the time said manufactured homebuilders would get stuck holding a bag full of bad loans. However, Buffett knew that Clayton was an extremely well-run company. In sharp contrast to many other firms in the industry, Clayton's management prided itself on being conservative in its lending practices. The company tended to seek out higher-quality borrowers who wouldn't default when times were bad, even if it meant turning away potential customers.

In this case, Buffett managed to uncover a stellar value investment simply because Wall Street had painted Clayton with the same brush as the rest of the industry -- despite the fact that the company was far more conservative and less vulnerable to rising interest rates. In short, Buffett's assessment of Clayton's value was right on target. And as a result, he managed to earn tremendous returns by purchasing the stock at a steep discount to its intrinsic value.

(2.)  What Tools Can Investors Use to Identify Quality Value Stocks?


While value investing can be highly profitable, no one ever said it was easy. 

To begin, it can be quite difficult to accurately determine the true intrinsic value of a firm. Such calculations always involve unknown variables and assumptions about the future that may or may not play out according to plan. Furthermore, uncovering mispriced stocks can be a time-consuming and research-intensive task. In the case above, for instance, Buffett undoubtedly put months of research delving into Clayton's background. Finally, even when a value investor is spot-on with his assumptions, it may take a while for the rest of the market to reach the same conclusion -- meaning undervalued stocks can remain that way for extended periods of time before other investors finally catch on.

Nbi88ertheless, as the historical returns outlined above show, all of this work can be well worth the effort. While there is no single metric that will allow investors to uncover the best value plays, our research staff at StreetAuthority takes a number of factors into consideration when looking for solid value candidates. Here are just a few of our favorites:

Price-to-Earnings (aestate4)
Ask most investors to define value investing and they'll likely mention P/E ratios. By itself, a stock's price tells us very little; it must be placed in the proper context. This widely used ratio provides us with an important measure of a company's stock price in relation to its earnings. As most investors know, a firm's P/E ratio is calculated by dividing its current stock price by its earnings per share (EPS). The result essentially indicates how much investors are willing to pay for each dollar of a particular company's earnings. All else being equal, the lower a firm's P/E ratio, the better value the stock is relative to its current earnings base.

#-ad_banner_2-#While the math behind this measure is fairly straightforward, investors do have several different variations to choose from. Some rely on trailing earnings numbers -- these are based on the company's actual earnings over the previous 12-month period. Meanwhile, others prefer to look at forward P/Es, which are based on analysts' earnings estimates for the year ahead (or even further in the future). We prefer to examine both trailing and forward values, as they can both yield important clues. For example, if a company's forward P/E is well below its trailing P/E level, then this may prove to be a warning sign that analysts are overly optimistic about the firm's future.

It's also important to remember that P/E ratios are meaningless when examined in isolation and can be misleading when used to compare stocks in different industries. Because different industry groups don't share the same fundamental characteristics, they tend to trade within different average P/E ranges. Therefore, it wouldn't be appropriate to measure the P/E of say, a regional bank, against that of a software firm. 

Finally, growth rates must also be taken into consideration. For example, a company trading at 20 times earnings and posting reliable earnings growth of +40% per year might be a much "cheaper" stock than a company with flat growth that's selling for just 10 times earnings. Therefore, it's best to also keep an eye on the PEG which we explain below. 

P/E-to-Growth Ratio (PEG)
By incorporating a firm's expected future growth into the equation, ebt ratios help us to eliminate one of the major shortfalls of pure P/E comparisons -- the effect of estimated growth. PEG ratios can be calculated by dividing a company's P/E by the firm's long-term estimated annual growth rate. For example, a company with a P/E of 15 and projected growth of +20% per year would have a PEG of 0.75 (15/20 = 0.75). As a simple rule of thumb, stocks that sport PEGs of less than 1.0 are considered to be relatively decent values.

Although the PEG ratio is an extremely useful measure, it's far from foolproof. Very high-growth companies can PEG above 1.0, yet still be decent long-term values. And don't fall into the trap of believing that all companies with PEGs under 1.0 are good investments. After all, poor or unreliable growth estimates can easily throw off the calculation. With these potential pitfalls in mind, when looking for a quality Value Stock, investors need to consider a number of other factors in PEG. (Since no perfect financial indicator exists, the same could be said of all other ratios.)

Cash Flow/Enterprise Value (Cash Flow Yield)
As we explained above, a company is worth only the sum of the future cash flows it can generate from its business. With this in mind, value-conscious investors should always examine a firm's cash flows before making any investment. 

As we mentioned earlier, the P/E ratio is by no means a perfect measure. A firm's net income is merely an accounting entry. As such, it is often impacted by a number of non-cash charges like deprPEGation. Also, companies can use a variety of accounting tricks to manipulate or distort their earnings from quarter to quarter. By contrast, cash flow measures the actual money paid out or received by a company over a certain period of time. 

Cash flows strip out the impact of non-cash accounting charges like depreciation and amortization. And, more importantly, cash flows are entirely objective. There is no value judgment about when and how revenues are recognized -- the cash flow statement only recognizes the actual cash that flows into or out of a business. By excluding extraordinary one-time items (like asset sales), operating cash flow shows the true profitability picture of a firm's core operations. 

Again, though, it makes little sense to evaluate cash flows in isolation. Always mindful of valuation levels, we like to compare a company's operating cash flow to its Enterprise Value. This gives us a better sense for the amount of cash a company is generating each year relative to the total value (both debt and equity) investors have assigned to the firm.

For those of you unfamiliar with the term, enterprise value (EV) is a way of adjusting market capitalization to more accurately reflect a firm's true value. EV is calculated by taking a company's market capitalization (price per share times the number of shares outstanding), then adding debt and subtracting the firm's cash balance. This makes EV an excellent reflection of the total value an investor would receive if he/she purchased the entire firm -- the investor would have to pay off a firm's debt but would get to keep the cash on the books.

By dividing a company's operating cash flow by its enterprise value, we're able to calculate the firm's operating cash flow yield (OCF Yield). This measure reflects how much cash a company generates annually compared to the total value investors have placed on the firm. All things being equal, the higher this ratio, the more cash a company generates for its investors. Companies with high OCF yields are much more likely to end up being excellent value stocks.

Return-on-Equity (ROE)
ROE provides investors with another excellent tool to help uncover value stocks and is a favorite of Warren Buffett. The calculation of ROE is simple: divide a company's net income -- defined as total profits after interest, taxes, and depreciation -- by its shareholder's equity. Shareholder's equity is an accounting estimate of the total investment equityholders have made in a firm, and it can be found as a line item on a company's balance sheet. This ratio measures the profit a company produces relative to shareholders' investment in the firm. Because this measure is widely used, almost all financial websites list ROE values for most publicly traded companies.

When searching for value-oriented investment ideas, we typically look for companies that have shown stable or rising ROEs in recent years. However, there are caveats. For example, if a company has a particularly strong year (or books a one-time gain), then its net income figure can be temporarily inflated, leading to exceptionally strong ROE values. Many tech companies, for example, produced enormous ROE in 2000, only to see reduced profitability (and ROE figures) the next few years. 

Another point to consider is the relationship between ROE and debt. By taking on higher and higher debt loads, companies can substitute debt capital for equity capital. Thus, companies with greater debt loads should be expected to have higher ROE than companies with cleaner balance sheets. 

The ROE measure, along with return-on-invested-capital (acost basisC), provides some insight into how efficiently a company deploys its capital. Those with a "grow at any cost" mentality can post respectable growth rates, yet still destroy shareholder value. To weed out these firms, we typically prefer companies that have ROE figures in the mid-teens or better -- roughly the historical average of the S&P 500. 

Discounted Cash Flow (DCF) Analysis
DCF modeling is a rather sophisticated analytical tool that many Wall Street pros use to gauge a firm's intrinsic value. Essentially, the process involves forecasting a firm's future cash flow stream, then discounting those cash flows back to the present at a rate sufficient to compensate investors for the risk taken. By adding up the present values of all future cash flows and dividing by the current number of shares outstanding, we come up with an estimate of the firm's intrinsic value per share. 

As might be expected, the numbers that come out of this calculation are only as good as the numbers that go in -- poor growth projections and unrealistic discount rates can yield wildly off-base net income figures. To minimize risk in the event that future financial performance deviates from the assumptions baked into the calculation, most value investors demand a wide margin of safety before investing. In other words, they might not purchase a stock with a $50 per share intrinsic value unless it was trading at $40 or below. The higher the degree of uncertainty, the larger the required margin of safety.

When used in conjunction with traditional valuation metrics like price-based ratios, DCF analysis can be a powerful tool to ai the value hunter. 



 

(3.)  How Should You Look for Value Stocks?


Unfortunately, there's no predetermined formula that will allow investors a clear-cut path to uncover the best value plays. Investing is always a delicate balance of both art and science.

Next, consideration should also be paid to the company's industry and whether or not the firm has a recognizable edge over ai peers. Always try to invest in companies that benefit from a variety of distinct and defensible competitive advantages. These advantages could take the shape of a powerful brand name, a unique product, or miten a patented technology. Remember, companies with sustainable competitive advantages are much more likely to maintain a high level of profitability than those without them.

It is also a good idea to determine whether a company operates in a cyclical market. Some firms -- such as automakers -- typically see their fortunes rise and fall with changes in the economy. The performance of these firms is often tied to broad macro-economic factors; they may look attractive when times are good, but they're also vulnerable to economic slowdowns. In other words, ask yourself whether or not the company's economic moat is wide enough to protect the firm's profitability under difficult conditions. 

Knowledge is power, and it is always important to know as much about a prospective company's operations as possible. This includes a thorough look at its industry, its vendors, its customers, its competitors, etc. Digging through old press releases posted on financial websites is a good starting point. The company's most recent quarterly and annual reports should also be required reading. 

Keep in mind, though, that press releases written by a firm's investor relations department will nearly always paint the company's prospects and results in the most favorable light possible. Therefore, it is important to balance that information with objective analysis from other sources. 

Remember, the most valuable articles or bits of information can sometimes run contrary to your opinion on a company. In other words, don't fall prey to ignoring possible warning signs simply because they challenge your thesis on a stock; instead try to poke holes in your own arguments. This will help eliminate costly investing mistakes and allow you to invest with more conviction. 

Successful value investing doesn't necessarily involve uncovering an abundance of potential picks; the key is to be right when you do find a good one. When you've finally made up your mind, invest with confidence and hold for the long term.