Deeper dives on diversification, wealth-building, and making the most of every investment
October 18, 2019
Value investors analyze the market for stocks that have been undervalued so that they can maximize their profits. In order to accurately judge the valuation of a stock, investors must have access to several different metrics. The range of information provided by these five measures will provide any potential investor with enough data to make a sound and informed decision.
The price-to-book ratio is calculated by comparing the worth of a company’s net assets to the price of its shares. The P/B ratio doesn’t ordinarily factor in future growth so the ratio is based on verifiable data and is often considered more reliable than other metrics.
The P/B ratio is sometimes preferred by more conservative investors. If the ratio is less than 1, the implication is that the market value is lower than its book value and so represents good value to a would-be investor. An investment based on a low P/B ratio relies on the market value being incorrect.
A price-to-earnings ratio is determined by comparing a company’s share price to its past or future earnings. A stock with a price that is high in relation to the company’s earnings is a poor investment. The main goal of a value investor is to discover whether a stock valuation is accurate and the P/E ratio is a quick and easy way to do so.
However, P/E ratios are not infallible and rely on the accuracy of earnings reports and analysis. It’s extremely difficult to predict the future earnings of a company, as there are many unseen variables that could impact it.
The free cash flow, or FCF, of a company is simply how much cash a company makes through its enterprise after all expenses have been accounted for. FCF is nearly always a solid indicator of company health and is an important factor in whether the business will have enough capital to fund dividends and other shareholder payments.
There is often only a short period of time between when a company’s FCF increases and their share price follows suit, so it can be lucrative to invest at the right moment. Spotting discrepancies between FCF and share price is incredibly helpful in making profitable financial decisions.
The amount of debt a company has compared to the total value of its shares is known as the debt-equity ratio and can be a reliable measure of the true value of a stock. There are always exceptions but generally, a low ratio is indicative of a healthier financial outlook whereas a higher ratio should normally be avoided.
In the right hands, debt can be a sign that a company is investing heavily to expand and increase profits, but it can also be a sign of mismanagement. The importance of a low debt-equity ratio also varies between industries, so gather as much information as you can about the company and its competitors to put the ratio in a clearer context.
The price-to-earnings growth, or PEG, ratio is a calculation of the P/E ratio with the company’s predicted growth factored in. A change in company earnings over a set period is used to ascertain the growth rate from which the ratio is calculated.
A PEG ratio can be a good basis for investment but it contains the inherent risk involved with any calculation based on predictions. Growth rates are rarely constant so are liable to change regularly and rapidly. Investments based on favorable PEG ratios flirt with increased uncertainty in the pursuit of profits.
Value investors mostly use a combination of as many metrics as possible before making any significant financial decision. Each individual measure has its benefits but also its drawbacks, so it is always prudent to gain a comprehensive understanding of any risk before taking an executive decision on your fiscal prosperity.