A value investor, or an investor who looks for value opportunities, can be described as an individual or group who actively hunts down stocks that could be considered undervalued. Undervalued is a relative term of course, but in this case, value investors seek out company’s stock whose longer-term qualitive and quantitive data (known as fundamentals) have not been adequately taken into consideration with regards to the price of that company’s stock.
This approach to investment is brought about by an underpinning belief among these types of investors that the market is overly reactionary, and doesn’t give enough consideration to these fundamentals, thus leading to opportunities when the stock of a company has been, in the short-term at least, deflated more than it should have been. Warren Buffett of Berkshire Hathaway, is perhaps the world’s best-known investor who operates in this way.
Basic metrics for measuring a company's stock
It’s a longer-term approach, of course, and not the strategy short-termists would apply, but when it comes to investing there really is no one correct way of doing it. That said, detailed analysis points to the fact that making value investments can in fact outperform what are known as growth stocks over the long term, but then not everybody wants to take this approach in terms of time frame.
What can be said is that value investors use a very scientific way of looking at the value of stocks involving financial ratios. They look for certain metrics which they believe are a giveaway that a company’s fundamentals are better than what the market is presenting at the time. So, what are these metrics exactly?
This is an important place to start for any investor as the price-to-earnings ratio (P/E) compares the current market value of the company's stock to the company’s earnings. As a metric, it gives you details of what the market price is judged against earnings at any one time, and is often a good indicator as to whether a stock is overvalued or undervalued. Obviously, value investors are looking for the latter.
One caveat here is that there are limits to what P/E can tell you, and also the value itself is often determined by analysists, who can be and are sometimes wrong in their valuations. Past earnings will not always tell you exactly what future earnings will be, for example.
Price-to-Book Ratio of a company's stock
The price-to-book ratio (P/B) is another indication of whether a company is overvalued or undervalued by looking at the company’s net assets next to the price of all of that same company’s shares that are outstanding. What it really tells you is the price that investors would pay for the company’s assets (measured per dollar).
“The P/B ratio, in essence, allows value investors to make a comparison between market value and book value, so is another way to ascertain if a company's stock is undervalued, which is exactly what they are looking for, and the more undervalued the better,” states Max Harrison, a marketing writer at Writinity and LastMinuteWriting.
It’s always important to understand how a particular business structures the finance behinds its assets, and this particular metric is a way of measuring the amount of equity in relation to debt a company has accrued.
“Of course, a lower amount of debt is good to see here, in terms of debt-to-equity,” states Sandra Bronson, a tech blogger at DraftBeyond and ResearchPapersUK. “This all boils down to risk, because all company’s must meet their obligations when it comes to debt. These ratios can be quite different depending on the industry, for example, and other factors would be what the company is trying to achieve in the current time. An ambitious expansion will likely rack up a higher amount of debt in the short term, so it’s not a clinching number on its own.”
Free Cash Flow
Free cash flow (FCF) is simply the amount of cash being generated by the business in its day-to-day activities, irrespective of assets and only after all obligations and expenses are accounted for. A business that is generating plenty of free cash flow is obviously in rude short-term health, so it is a positive sign, but again the bigger picture must be sought, even though FCF often indicates improved future earnings. Low share prices combined with positive FCF numbers are a great sign, however.
PEG is the price-to-earnings-to-growth ratio, and is basically an adaption of the P/E which now considers earnings growth as well. That’s because P/E ratio on its own will not factor in the all-important growth rate of the company that is predicted. This basically gives investors a better macro-level view of the prospects of the company, and is therefore an important part of ascertaining if a company's stock is underperforming or not, and it considers the future too, which is what all value investors are looking towards.
Conclusion of valuation of a company's stock
These are the classical financial ratios that value investors look at in the hunt for what is known as a value investment. But it is always important to remember that no one investor, or group of investors, would necessarily look at the same metrics each and every time, the important metrics can vary from industry to industry, and not all investors are looking for the same thing from their returns in any case. What can be said is that, as a strategy, value investing has a good track record, and can lead to success over the longer-term, but in the world of investments, there are very few guarantees.
About the Author
Professional writer, marketing, management and recruitment expert Ashley Halsey can be found contributing her business insights at LuckyAssignments and GumEssays, where she has established her reputation as an erudite and intelligent observer of marketing trends.