If you're a value investor, there's no "right way" to analyze a stock. Even so, any successful investor will tell you that focusing on certain fundamental metrics is the path to cashing in gains. That's why you need to keep your eye on the metrics that matter.
As a value investor, you already know that when it comes to a company's health, the fundamentals are king. Fundamentals, which include a company's financial and operational data, are preferred by some of the most successful investors in history, including the likes of George Soros and Warren Buffett. (See also: The World's Greatest Investors) That's no surprise, as knowing the ins and outs of a company's financial numbers - like earnings per share and sales growth - can help an in-the-know investor weed out the stocks that are trading for less than they're worth.
But that doesn't mean that all metrics are created equal – some deserve more of your attention than others. Here's a look at the five must-have fundamentals for your value portfolio.
1. Price-to-Earnings Ratio
The price-to-earnings ratio (also known as the P/E ratio or earnings multiple) is one of the best-known fundamental ratios, and rightfully so. It's also one of the most valuable. The P/E ratio divides a stock's share price by its earnings per share to come up with a value that represents how much investors are willing to shell out for each dollar of a company's earnings.
The P/E ratio is important because it provides a measuring stick to compare valuations across companies. The ratio determines how much an investor would have to pay for each dollar in return. Another way of putting it is that a stock with a lower P/E ratio costs less per share for the same level of financial performance than one with a higher P/E. Naturally, an investor would want to pay less for the same return, which essentially means that a P/E ratio is the way to go.
Keep in mind that the P/E ratio should not be compared across different industries. While it's completely reasonable to see a telecom stock such as Verizon or AT&T with a P/E in the teens, a P/E ratio of closer to 30 is perfectly normal in the lodging industry, in fact it's the industry average. As long as apples are compared to apples, the P/E ratio can give an excellent glimpse at a stock's valuation. (See more: Investment Valuation Ratios Tutorial)
2. Price-to-Book Ratio
If the P/E ratio is a good indicator of what investors are paying for each dollar of a company's earnings, the price-to-book ratio (or P/B ratio) is an equally good indication of what investors are willing to shell out for each dollar of a company's assets. The P/B ratio divides a stock's share price by its net assets, less any intangibles such as goodwill.
Taking out intangibles is an important element of the price-to-book ratio. It means that the P/B ratio indicates what investors are paying for real-world tangible assets, not the harder-to-value intangibles. As such, the P/B is a relatively conservative metric.
That's not to say that the P/B ratio isn't without its limitations; for companies that have significant intangibles, the price-to-book ratio can be misleadingly high. For most stocks, however, shooting for a P/B of 1.5 or less is a good path to solid value. A low P/B ratio can indicate an undervalued company, however, it can also be a sign of a company in distress. (See also: Digging Into Book Value)
Knowing how a company finances its assets is essential for any investor – especially if you're on the prowl for the next big value stock. That's where the debt/equity ratio comes in. As with the P/E ratio, this ratio, which indicates what proportion of financing a company has received from debt (like loans or bonds) and equity (like the issuance of shares of stock), can vary from industry to industry.
Beware of above-industry debt/equity numbers, especially when an industry is facing tough times – it could be one of your first signs that a company is getting over its head in debt. For example, Lehman Brothers had a debt/equity ratio of over 30:1 in 2007 before the bankruptcy. That means that for every dollar of equity, the bank had $30 in debt. (See more: Case Study: The collapse of Lehman Brothers)
4. Free Cash Flow
Perhaps unbeknownst to many, a company's earnings is rarely equal the amount of cash it brings in. That's because public companies report their financials using GAAP or IFRS accounting principles – or accrual accounting – not the balance of the corporate checking account. So while a company could be reporting a huge profit for its latest quarter, the corporate coffers could be bare.
Free cash flow solves this problem. It tells an investor how much actual cash a company is left with after any capital investments. Generally speaking, an investor wants positive free cash flow. As with the debt-equity ratio, this metric is all the more significant when times are tough. (See also: Free Cash Flow: Free, But Not Always Easy )
5. PEG Ratio
The price/earnings to growth ratio (or PEG ratio), is a modified version of the P/E ratio that also takes earnings growth into account. Looking for stocks based on their PEG ratios can be a good way to find companies that are undervalued but growing, and could gain attention in upcoming quarters. Like the P/E ratio, this metric varies from industry to industry. (See also: Move Over P/E, Make Way For The PEG)
Going Beyond the Numbers
When it comes to investing, ratios aren't everything. There are times when low valuations are justified, and there are qualitative metrics – like management quality – that also factor into a company's valuation. Just because a stock seems cheap doesn't mean that it deserves to increase in value.