Value investing has evolved ever since the days of Ben Graham. When buying stocks just based on low price/to/earnings and price/to/book was a sure way to beat the market. Things today are very different.
Today, there are stock screeners, and other tools that make it extremely easy to find potentially undervalued stocks. This is one of the reasons so many investors are able to find and cover the same stocks. Making it nearly impossible to find a stock that is in deep value territory unless it is on an emerging market. So what should value investors do?
Firstly we need to reconstruct the definition of a value stock forever. A value stock is not a business that is trading at a low valuation. It is a stock that is worth more today than in the future. What does this mean for the valuation process, and how to build your investment thesis?
The implications of embracing these changes will change the way you analyze stocks. You cannot rely anymore on a few metrics to determine whether a stock is a value stock. Let’s look at some of the most important ratios that were once a requirement for value stocks.
Although some investors obsess about price-to-earnings there are other metrics that are more useful. A price-to-earnings should always be compared with the broader market. If it is considerably lower than the average of most stocks, it can mean two things:
- The company had great short-term earnings that are expected to decline
- Earnings are expected to be lower in the future
This does not mean that you should discard every stock that has a low price-to-earnings. Instead, value investors should try to deeply understand why the P/E is low. Buying stocks outright with low P/E ratios might have worked in the past, but not anymore.
You may use a screener to find value stocks with low price-to-earnings, but you also need to dig in deeper and deeply understand why the market is attributing that valuation multiple to the business.
A low price-to-book was also one of Ben Graham’s advice to find value stocks. Nowadays, a low price-to-book simply indicates that the market is not attributing a lot of value to the company’s assets.
This may be a temporary signal, or it may have other deeply rooted reasons. In order to understand why the P/B ratio is low, analyze the balance sheet. Read every line on it, and try to compare it across different periods of time.
You will find that some of the companies trading at the lowest price-to-book ratios will often have overvalued assets or understated liabilities. Another reason that could explain the low book value is that the expected return on equity for the company will be low.