Value investors get a bad rap. Sometimes, value investing is referred to as “cigar butt” investing, in that picking up cheap, undervalued stocks is equivalent to picking up mostly smoked cigars off of the sidewalk. A good friend and colleague of mine used to call me a “dumpster diver”. Guilty.
Why value? Personally, I hate overpaying. The old Wall Street maxim “buy low, sell high” is in direct conflict with “buy high, sell higher”. Typically, value stocks are less volatile than growth stocks. That doesn’t mean they’re less risky.
I’m not going to argue the outperformance of growth versus value. Sometimes growth outperforms. Sometimes value outperforms. I’m also not going to get lost in the weeds of grandfather of value investing Benjamin Graham’s notion of intrinsic value and margin of safety.
What I will do is point out three key indicators that will get the ball rolling in evaluating a value stock.
1. Forward P/E
I’ve found that the most useful metric used in determining a stock’s value is the price-to-earnings ratio (P/E). A stock’s P/E ratio measures its price relative to the underlying business’s earnings per share (EPS). The trailing P/E measures past earnings while the forward P/E is calculated with projected earnings. The forward P/E is my go-to valuation metric. A low forward P/E is an indicator of the marketplace’s confidence in the ability of the company to deliver on the earnings forecast. The lower the number, the less confident the market is, and thus the cheaper the stock.
It’s also helpful to compare the stock’s forward P/E to that of the benchmark. If the S&P 500’s average forward P/E is 23 and the stock you are considering has a forward P/E of 14, that stock is trading to a 39.1% discount to the market on a forward P/E basis and could be a good value. You can (and should) also compare a stock’s forward P/E to those of its industry peers.
2. Price To Sales
Another useful metric is the price-to-sales ratio (P/S). P/S measures a company’s market cap versus its annual revenue number. The idea is that the lower the number, the greater the implied value. For example, Snap, Inc. (Nasdaq: SNAP) trades at 26.9 times sales, an incredibly expensive number. However, aftermarket auto parts giant Genuine Parts (NYSE: GPC) trades at just 0.88 times sales — 88 cents to every dollar of sales the company brings in. Often, the lower the number, the more inefficiently the market has mispriced the stock.
3. Hidden assets
This is a tricky one. Usually, these assets aren’t exactly hidden. They show up on the balance sheet and in the financial reports. However, due to the company’s stock being out of favor, the market in its infinite herd mentality is either deeply discounting or possibly altogether ignoring the obvious value of a crucial, tangible asset. It could be something as simple as cash on the books, a subsidiary, or, more often than not, real estate.
The best current example of this is Macy’s, Inc. (NYSE: M).
Thanks to disruption in the retail sector, the stock has lost more than 60% of its value over the last two years, shrinking the retailer’s market cap from $18.6 billion to around $7.7 billion. But, analysts estimate the value of Macy’s real estate portfolio to be around $21 billion dollars. Its flagship Herald Square store in New York City alone is worth nearly $4 billion. Anecdotal evidence suggests that the company is mulling a plan to convert a portion of the Herald Square property into leasable office space, thus unlocking value and increasing revenue from an unlikely source.
The market, however, is panic selling based on the here and now: the day of reckoning for bricks and mortar retailing has finally come and the internet will deliver the death blow. Like the plague-afflicted character in Monty Python and the Holy Grail said: “I’m not dead, yet!”
Action To Take: These three criteria just scratch the surface of value investing which, as an investment discipline has many nuances. While this is enough to get you started, the most important aspect of value investing is patience. Don’t buy without it.
Editor’s Note: Can you read a stock’s “tell”? It’s the distinctive sign that stocks give just before they take off. We’ve already made $421,000 using this telltale giveaway. Here’s how you can use it too…