My Handy, Dandy GICS Table
Finding the Right Formula Will Increase Your Profits
Six Price Multiples to Determine a Stock’s Value
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Growth Investing and Value Investing
Are you a growth investor or a value investor?
I find a lot of investors are confused about growth investing versus value investing. The confusion is created because the two types of investing are intertwined. Growth investors are looking first for companies with good growth prospects and evidence that investors are buying in. Value investors, though, are initially looking for companies that are undervalued, but also have good growth prospects. Simply stated, growth investors place their priority on growth and momentum with value secondary, whereas value investors stick to valuations.
Valuation is at the center of all investing. Even if you are a growth investor, the value of your company should be taken into account. If two companies’ sales and earnings are growing at the same rate and their future growth prospects are exactly the same, is one a bargain and the other over-priced? Based upon estimates, is one selling at a much smaller price to earnings ratio than the other? To find out, look beyond growth prospects. Check out the intrinsic value of each company by using the appropriate measures, explained below.
Value Considerations
You should assess the value of a company using an appropriate valuation method so that you can compare your value assessment to the current market price. Doing otherwise is to speculate, not invest.
All valuation methodologies are not created equal. No single method applies to all companies or succeeds in all market conditions. The price of a security is based on a number of tangible and intangible factors such as the current status of the company, the prospects for the company, market sentiment, and many other factors.
Intrinsic value is what you believe the company is worth, independent of outside factors that may be influencing the price and which are beyond our control. We evaluate a company to find its intrinsic value, and then determine if the company’s price is reasonable compared to its intrinsic value.
There are many analyses available to find a company’s intrinsic value, but most of these methods are somewhat complicated. There are a few simple yardsticks, however, which will provide worthwhile indications of whether your growth stock or value stock is undervalued. The key to using simple yardsticks is to use the right yardstick to measure each type of stock. Here are a few guidelines.
Price Multiples
Standard & Poor’s divides the entire business spectrum into 10 sectors and 24 industry groups. S&P’s classifications are known as the Global Industry Classification Standard (GICS). These classifications determine which price multiples I use to value a company. All companies fall into the following business sectors and industry groups, depending on a company’s principal business activity:
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In my own work, I apply six yardsticks, or price multiples, to help me find which companies are undervalued. I do not, however, use all six for each company, I use just one or two. The price multiples are: P/BV, P/CF, P/D, P/E, P/S and PEG ratios.
The P/BV (price to book value) ratio is calculated by dividing the current stock price by the latest reported book value (or net asset value) per share. I consider the current stock price for a company to be undervalued if the P/BV ratio is less than 1.00. The ratio is best used when evaluating companies in the Energy, Materials and Financials sectors. My favorite company with a low P/BV ratio operates an Oil & Gas Drilling business in the Energy sector. The company’s P/BV ratio is 0.87, well below my 1.00 cutoff, and sales and earnings growth prospects are excellent for the next several years.
The P/CF (price to cash flow) ratio is calculated by dividing the current stock price by the latest four quarters of reported cash flow (or change in cash position) per share. I consider the current stock price for a company to be undervalued if the P/CF ratio is less than 8.00. The ratio is best used when evaluating companies in the Consumer Discretionary and Industrials sectors. My favorite company with a low P/CF ratio is an automobile manufacturer in the Consumer Discretionary sector. The company’s P/CF ratio is 3.40, less than half my 8.00 cutoff. Sales and earnings growth prospects look bright for the next several years.
The P/D (price to dividends) ratio is calculated by dividing the current stock price by the latest annualized quarterly dividend (quarterly dividend time four) per share. The inverse of the price multiple is Div/Price, which is the dividend yield for a company. I consider the current stock price for a company to be undervalued if the P/D ratio is less than 50.00. The ratio is best used when evaluating companies in the Health Care, Financials and Utilities sectors. My favorite company with a low P/D ratio (high yield) operates an Asset Management business in the Financials sector. The company’s P/D ratio is 12.59, way below my 50.00 cutoff (and with a 7.99% yield). Sales and earnings growth prospects are clearly improving for the next several years.
The P/E (price to earnings) ratio is calculated by dividing the current stock price by the latest four quarters of reported earnings (or profits) per share. I consider the current stock price for a company to be undervalued if the P/E ratio is less than 12.00. The P/E ratio is sometimes the least reliable price multiple, because companies adjust earnings per share using different criteria and standards. The ratio is best used when evaluating companies in the Energy, Materials and Financials sectors. My favorite company with a low P/E ratio operates an Asset Management business in the Financials sector. The company’s P/E ratio is 7.19, well below my 12.00 cutoff, and sales and earnings growth prospects are excellent for the next several years.
The P/S (price to sales) ratio is calculated by dividing the current stock price by the latest four quarters of reported sales (or revenues) per share. I consider the current stock price for a company to be undervalued if the P/S ratio is less than 1.00. The ratio is best used when evaluating companies in the Consumer Discretionary and Consumer Staples sectors. My favorite company with a low P/S ratio is an automobile parts maker in the Consumer Discretionary sector. The company’s P/S ratio is 0.38, less than half my 1.00 cutoff. Sales and earnings growth prospects look very bright for the next several years.
The PEG (P/E to projected EPS growth) ratio is calculated by dividing the current stock price by the latest four quarters of reported EPS (earnings) per share, and then dividing the result by projected EPS growth for the next three to five years. I consider the current stock price for a company to be undervalued if the PEG ratio is less than 1.00. The ratio is best used when evaluating growth companies in any of the sectors. My favorite company with a low PEG ratio is a biotechnology company in the Health Care sector. The company’s PEG ratio is 0.66, well below my 1.00 cutoff. Sales and earnings growth prospects are excellent for the next several years.
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Growth and Value Investing Made Easy
So how can you use all of this information to become a better investor and make better choices? It’s easy.
For growth investors, you should find companies using your usual growth measure, which might include strong stock price and/or earnings momentum. Next, figure out which sector the company belongs in by reading about what the company does. (Note: according to Warren Buffett, if you don’t understand what the company does, you probably shouldn’t invest in it!) After identifying the sector where your stock resides, use the price multiples described above to determine if your growth stock is reasonably priced.
For value investors, I recommend finding companies using at least one low price multiple. Keep in mind that an extra, extra low price multiple might indicate that there are problems in the company’s future. If the multiple seems to be too good to be true, investigate! After determining the sector to which the company belongs, test if the recommended price multiple is low. Finally, analyze the company’s current growth pattern and find sales and earnings growth forecasts for the next several years.
If two companies are valued alike with the same price to sales, price to earnings, and price to book value ratios, but one company is set to grow at a 15% clip during the next five years or more, and the other company is probably not going to grow at all, you definitely will want to invest in the company with good growth prospects and pass on the company, although undervalued, with little or no growth potential.
We can draw a simple conclusion here: don’t invest unless you bring both growth and value into your analysis. Ignoring either one will eventually get you into a heap of trouble.
My Special Offer
I have described six yardsticks called price multiples that I use to determine if a stock is undervalued. After introducing these price multiples, I have also mentioned six companies which I find exciting, with one company selected for each type of multiple.
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Until next time, be kind and friendly to everyone you meet.
Sincerely,
J. Royden Ward
Chief Analyst of Cabot Benjamin Graham Value Investor
You can read more about P/E, P/BV and PEG ratios and receive complete coverage in my Cabot Benjamin Graham Value Investor. There you’ll not only find buy and sell advice for the six stocks described above, you’ll also discover additional stocks selling at bargain prices. In every issue, you’ll find my legendary Maximum Buy and Minimum Sell Prices for over 275 stocks plus my up-to-date predictions for the Dow Jones Industrial Average.
