With the art of picking lowly valued stocks playing such a central role in any value investing strategy, it is essential for the investor to get acquainted with the necessary tools to make a proper assessment. While not many investors managed to make it to accountancy school, there are a few shortcuts available to understand a company’s valuation and its business quality.
These generally come down to understanding a few simple ratios that help isolate both cheap stocks in terms of valuation ratios, but also good stocks in terms of their operating ratios.
When an investor buys a company he’s buying the company’s assets but also a claim on the future earnings of that company. As a result it’s unsurprising that the top two things that Value Investors try to do is to buy assets on the cheap or earnings on the cheap.
While some financiers specialise in evaluating these things in extremely complicated ways, plenty of star investors such as David Dreman and Josef Lakonishok have had great success just focusing on the simplest ratios like the P/E Ratio and P/B Ratio which we describe in this article.
When using valuations ratios such as these its important to take a couple of things into account. Firstly, investors should compare the ratio for the company in question against the market and the sector peer group but also against the company’s own historical valuation range. By doing this the investor can not only find cheap stocks in the current market environment but also make sure they aren’t being caught up in frothy overall valuations.
There are risks to using these kinds of ‘relative valuation’ ratios that we’ll discuss in a forthcoming article, but nonetheless the following six ratios are essential weapons to keep sharpened in the armoury.
1. Price to Book Value - buy assets on the cheap
The P/B ratio works by comparing the current market price of the company to the book value of the company in its balance sheet. Book Value is what is left over when everything a company owes (i.e. liabilities like loans, accounts payable, mortgages, etc) is taken away from everything it owns (i.e. assets like cash, accounts receivable, inventory, fixed assets).
It is worth noting that this book value often includes assets such as goodwill and patents which aren’t really ‘tangible’ like plant, property and equipment. Some investors remove…
