Warren Buffett buys quality merchandise when it is marked down, whether it is socks or stocks. His mentor, Benjamin Graham, taught him valuable lessons, one of which is that price is what you pay; value is what you get.
3D value investing has four principles. The number one principle is to always invest with a margin of safety. We do this because we understand there is a distinct difference between price and value. Value investors search for and identify sound value stocks trading at a discounted price. A stock's current share price doesn’t necessarily reflect its true market value. Therefore you need to valuate a company's shares to determine whether its stocks are trading below its intrinsic value.
How Do I Determine Whether a Stock is Trading Below its Intrinsic Value?
The fundamentals of a business can be regarded as its foundation. We use the process of fundamental analysis to determine the value of a company and its shares. There are numerous metrics you can use to fundamentally analyse a company, some more important than others. Different investing styles lead to various opinions on the matter, but there are simply some metrics that investors cannot afford to ignore.
The six most important value investing metrics to determine the value of a stock are:
1. Discounted Cash Flow Analysis
This valuation method is used to calculate the attractiveness of an investment opportunity. In other words, it calculates whether a stock is hot or not by using future free cash flow projections and discounting them to arrive at a present value. The calculated present value is then used to evaluate the potential for investment.
Tip: When the DFC value is higher than the current share price it may suggest a good investment opportunity. Using this analysis alone isn’t enough and should still be used in conjunction with other metrics.
2. Price to Earnings Ratio
The price to earnings ratio is a common ratio and is also referred to as the P/E ratio. It is a valuable metric, because it provides a measuring stick for comparing valuations across companies. It divides a stock’s share price by its earnings per share to determine the value that represents how much investors are willing to pay per dollar of earnings.
Formula: Price to Earnings Ratio = (Market Value per Share) / (Earnings per Share)
Tip: A high P/E ratio generally means that investors are anticipating higher future growth. Don’t compare P/E ratios of different industries with one another.
3. Price to Free Cash Flow
This metric compares market price to the level of free cash flow a company has on an annual basis. It is calculated by dividing market capitalisation by free cash flow. The higher the calculated measure, the more expensive the company.
Formula: Price to FCF = (Market Cap) / (Free Cash Flow)
Tip: Compare the company’s past level of price to free cash flow along with comparing the industry average.
4. Price to Tangible Book Value
This metric gives us a ratio of the price of a share compared to its tangible book value as reported in the company’s balance sheet. Tangible book value is basically true book value minus the value of all intangible assets.
Formula: PTBV = (Share Price) / (Tangible Book Value Per Share)
Tip: A lower price to tangible book value ratio is better than a higher one. When a stock trades at a higher price to tangible book value ratio it has the potential to leave investors with greater share price losses.
5. Enterprise Multiple (EV/EBITDA)
This ratio is important because unlike the P/E ratio, it takes debt into account. Enterprise multiple is commonly referred to as EV/EBITDA. The enterprise multiple is used for several reasons:
1) It ignores the distorting effects of individual countries' taxation policies and is therefore useful for transnational comparisons.
2) It is used to find attractive takeover candidates and is a better indicator than market cap for this specific purpose. It takes into account the debt which the acquirer will have to assume. Therefore, a company with a low enterprise multiple can be viewed as a good takeover candidate.
Formula: Enterprise Multiple = (Enterprise Value) / (EBITDA)
Tip: As with most of these metrics, the results can vary depending on the industry. Only compare companies within the same industry when using EV/EBITDA. High growth industries will have higher enterprise multiples, where you can expect low enterprise multiples in low growth industries.
6. Price to Sales
The price to sales ratio compares a company’s revenues to its stock price. It indicates the value placed on each dollar of a company’s sales or revenues.
Calculation: It can be calculated either by dividing the company’s market capitalisation by its total sales over a 12-month period, or on a per-share basis by dividing the stock price by sales per share for a 12-month period.
Tip: A low ratio may suggest the possibility of an undervalued company, where a high ratio may suggest an overvaluation.
STRIDE makes value investing easy. Learn how to start your portfolio now with our Practical Guide to Value Investing eBook below.