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Value investing: How to identify cheap stocks
At a time when the BSE Sensex is hovering around the same level as five years ago, it is a challenge for investors to find value. The stock market is not an easy game to play.
We often hear analysts use phrases like ‘stock valuation’, ‘PE ratio,’ ‘price-to-book’ among many other terms. The bottom line is that everyone wants to buy stocks with a ‘cheap’ valuation.
This strategy is called ‘value investing’ (started by American market guru Benjamin Graham in the 1930s). Accordingly, you select stocks by evaluating their intrinsic values.
But how does one identify such stocks? No, this is not reflected in its share price alone.
The value of a stock lies in the following five fundamental values:
Price-to-earnings ratio A price to earnings multiple or the P/E ratio compares a company’s share price and its earnings. It reflects how much investors are shelling out for each rupee that a company earns and provides a common tool for comparing various stocks. A higher P/E value means that investors are shelling out more for a company’s profit of one rupee as compared to another stock with a low P/E. However, it should not be used to compare companies from different industries. The P/E ratio is calculated by dividing the share price of the company by either the historical or expected earnings per share or EPS --- the company’s net profit divided by the total number of its equity shares. Analysts usually use the P/E ratio on the basis of expected earnings per share. It is called one-year forward multiple.
Return on equity The return on equity is the profit a company earns as a percentage of the total equity. The value of the stock is cheap if it is trading at a low historical price to earnings multiple, but has a high or a rising return on equity. This means that the company is generating profits but the share price is beaten down.
Price-to-book ratio The price-to-book or P/B ratio compares a company’s share price to its book value --- the value of a company per share if assets were liquidated. This metric is also used to identify cheap shares as a P/B ratio indicates how much investors are willing to pay for each rupee of a company’s assets. Moreover, this does not take into account intangible assets of a company like brand or goodwill, thus giving us the company’s real value.
Debt-to-equity ratio Companies raise funds via debt instruments for the production of goods and services. This debt is paid back over long-term periods. However, it is also necessary to access a company’s debt while investing to find out if a company is borrowing more than it should. This is calculated by dividing the total liabilities a company has raised via loans and bonds by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.
Price/earnings-to-growth ratio The price/earnings-to-growth or PEG ratio is a modified version of the P/E ratio. This is a metric which takes into account a company’s growth in earnings. This helps identify companies that are growing, but have cheaper stock valuations.
As of July 2013, the price-to-earnings ratio of Sensex is 17.34. The ratio is based on profits reported by companies in the year upto March 2013. This is lower than 21.05 witnessed in the financial year 2009-10 when the Sensex hovered around the same level. This means, comparatively, the Sensex is undervalued.