Value investors actively seek stocks they believe the market has undervalued. Investors who use this strategy believe the market overreacts to good and bad news, resulting in stock price movements that do not correspond with a company's long-term fundamentals, giving an opportunity to profit when the price is deflated.
Although there's no "right way" to analyze a stock, value investors turn to financial ratios to help analyze a company's fundamentals. In this article, we'll outline a few of the most popular financial metrics used by investors.
The price-to-earnings ratio helps investors determine the market value of a stock compared to the company's earnings. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E could mean that a stock's price is high relative to earnings and possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to earnings.
The P/E ratio is important because it provides a measuring stick for comparing whether a stock is overvalued or undervalued. However, it's important to compare a company's valuation to companies within its sector or industry.
Since the ratio determines how much an investor would have to pay for each dollar in return, a stock with a lower P/E ratio relative to companies in its industry costs less per share for the same level of financial performance than one with a higher P/E. Value investors can use the P/E ratio to help find undervalued stocks.
Please keep in mind that with the P/E ratio, there are some limitations. A company's earnings are based on either historical earnings or forward earnings, which are based on the opinions of Wall Street analysts. As a result, earnings can be hard to predict since past earnings don't guarantee future results and analysts' expectations can prove to be wrong. Also, the P/E ratio doesn't factor in earnings growth, but we'll address that limitation with the PEG ratio later in this article. 67
The price-to-book ratio or P/B ratio measures whether a stock is over or undervalued by comparing the net assets of a company to the price of all the outstanding shares. The P/B ratio is a good indication of what investors are willing to pay for each dollar of a company's assets. The P/B ratio divides a stock's share price by its net assets, or total assets minus total liabilities.
The reason the ratio is important to value investors is that it shows the difference between the market value of a company's stock and its book value. The market value is the price investors are willing to pay for the stock based on expected future earnings. However, the book value is derived from a company's assets and is a more conservative measure of a company's worth.
A P/B ratio of 0.95, 1 or 1.1, the underlying stock is trading at nearly book value. In other words, the P/B ratio is more useful the greater the number differs from 1. To a value-seeking investor, a company that trades for a P/B ratio of 0.5 is attractive because it implies that the market value is one-half of the company's stated book value. Value investors often like to seek out companies with a market value less than its book value in hopes that the market perception turns out to be wrong.
For more in-depth comparison of market and book value including examples, please read "Market Value Versus Book Value."
The debt-to-equity ratio helps investors determine how a company finances its assets. The ratio shows the proportion of equity to debt a company is using to finance its assets.
A low debt-to-equity ratio means the company uses a lower amount of debt for financing versus equity via shareholders. A high debt-equity ratio means the company derives more of their financing from debt relative to equity. Too much debt can pose a risk to a company if they don't have the earnings or cash flow to meet its debt obligations.
As with the previous ratios, the debt-to-equity ratio can vary from industry to industry. A high debt-to-equity ratio doesn't necessarily mean the company is run poorly. Often, debt is used to expand operations and generate additional streams of income. Some industries, with a lot of fixed assets such as the auto and construction industries, typically have higher ratios than companies in other industries.
Free cash flow is the cash produced by a company through its operations, minus the cost of expenditures. In other words, free cash flow or FCF is the cash left over after a company pays for its operating expenses and capital expenditures or CAPEX.
Free cash flow shows how efficient a company is at generating cash and is an important metric in determining whether a company has sufficient cash, after funding operations and capital expenditures, to reward shareholders through dividends and share buybacks.
Free cash flow can be an early indicator to value investors that earnings may increase in the future, since increasing free cash flow typically precedes increased earnings. If a company has rising FCF, it could be due to revenue and sales growth, or cost reductions. In other words, rising free cash flows could the stock reward investors in the future which is why many investors cherish FCF as a measure of value. When a company's share price is low and free cash flow is on the rise, the odds are good that earnings and the value of the shares will soon be heading up. For more on FCF including an example, please read "What's the Formula for Calculating Free Cash Flow?"
The price-to-earnings-to-growth (PEG) ratio is a modified version of the P/E ratio that also takes earnings growth into account. The P/E ratio doesn't always tell you whether or not the ratio is appropriate for the company's forecasted growth rate.
The PEG ratio measures the relationship between the price/earnings ratio and earnings growth. The PEG ratio provides a more complete picture of whether a stock's price is overvalued or undervalued by analyzing both today's earnings and the expected growth rate.
Typically a stock with a PEG of less than 1 is considered undervalued since it's price is low compared to the company's expected earnings growth. A PEG greater than 1 might be considered overvalued since it might indicate the stock price is too high as compared to the company's expected earnings growth.
Since the P/E ratio doesn't include future earnings growth, the PEG ratio provides a more complete picture of a stock's valuation. The PEG ratio is an important metric for value investors since it provides a forward-looking perspective.
For more on the P/E and PEG ratios, please read "How to Use The P/E Ratio And PEG To Tell A Stock's Future."
No single financial ratio can determine whether a stock is a value or not. It's best to combine several ratios to form a more comprehensive view of a company's financials, it's earnings, and its stock's valuation.