Value Investing: 7 Essential Criteria To Identify Undervalued Stocks

7 Essential Criteria To Identify Undervalued Stocks by John Szramiak was originally published on Vintage Value Investing

An Incredibly Powerful Value Investing Framework

When you buy a stock, you want to evaluate if its current price is higher or lower than what it’s worth over the long term.  All sorts of events which have nothing to do with a stock’s intrinsic value can affect its price, and frequently this means that stocks are undervalued.  For example, Steve Symington argues that CenturyLink is currently undervalued because investors haven’t yet accounted for the long-term impact of its imminent merger with Level 3 Communications, which, he predicts, “could be a fantastic driver of shareholder value.”

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What Is Value Investing?

Value investing identifies undervalued stocks.  The Motley Fool defines value investing in this way:

“Value investing consists of investing in stocks trading at prices below their intrinsic value. Value investors, therefore, are essentially buying stocks at a discount to what they believe they are worth, in hopes these investments will eventually rise to reflect their intrinsic value.”

Value investors understand the market often undervalues stocks based on news and events which have little if anything to do with the long-term fundamentals of those stocks.  They apply specific strategies to identify and invest in such stocks.

How to Evaluate Stocks: The Graham Model

Royden Ward, a value investor for decades, developed a computerized value investment stock selection model in 1969 based on the investment strategy of Warren Buffett – and his mentor, Benjamin Graham. In Cabot Benjamin Graham Value Investor, he lays out 7 criteria for value stock selection based on Graham’s theories:

  1. Quality rating

Ward recommends looking at stocks with a quality rating that is average or better.  Like Graham, he advises using Standard & Poor’s rating system to find out stocks with an S&P Earnings and Dividend Rating of B or better (on the S&P scale of D to A+).  To be safe, Ward says, it’s best to choose stocks with quality ratings of at least B+.

Value Investing Is Not Dead, But It Is Harder

  1. Debt to current asset ratio

In value investing, it’s important to select companies with a low debt load (this is especially important when lending is tight and the economy is relatively weak).  You should select companies with a total debt to current asset ratio of 1.10 or less.  There are a number of services which supply total debt to current asset ratios, including Standard & Poor’s and Value Line.

  1. Current ratio

The current ratio provides a good indication of how much cash and current assets a company has—something that demonstrates they can weather unanticipated declines in the economy.  You should buy stocks from companies with a current ratio of 1.50 or higher.

  1. Positive earnings per share growth

To avoid unnecessary risk, value investors look for companies with positive earnings per share growth.  Specifically, you should examine this metric over the past 5 years, and prioritize companies where earnings increase over that time period.  Above all, avoid companies which posted deficits in any of the last 5 years.

  1. Price to earnings per share (P/E) ratio

You should select stocks with low P/E ratios, preferably 9.0 or less.  These are companies that are selling at bargain prices (in other words, they’re undervalued).  This criterion eliminates high growth companies, which, according to Ward, should be assessed using growth investing techniques.

  1. Price to book value (P/BV)

P/E values are helpful, but they should be viewed contextually.  Specifically, you also need to consider the current price of a stock in relation to its book value, which gives you a strong indication of the underlying value of a company.   As a value investor, you want to invest in stocks which are selling below their book value.  The P/BV ratio is calculated by dividing the current price by the book value per share.

  1. Dividends

You should look at companies which are paying steady dividends.  Undervalued stocks eventually tick higher as other investors figure out they’re worth more than what their price suggests, but that process can take time.  If the company is paying dividends, you can afford to be patient as the stock moves from undervalued to overvalued.

Conclusion

The criteria which Ward uses provide a useful strategy to identify and invest in undervalued stocks—but it’s also important to understand the underlying conditions within a company which are the cause of its bargain price.  For example, a stock could be undervalued because the company is in an industry which is dying.

If a company is experiencing a problem which is the root cause of its undervaluation, you need to know if that problem is short or long-term, and whether the company’s management has a sound plan to address it.  Check out The Ultimate Guide to Value Investing to learn more.

 



About the Author

VintageValueinvesting
Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…