How to find Value in Stocks

If you are interested in how professionals value stocks and what metrics you can use to find good stocks then keep reading. First things first, it’s important to mention that there are infinite ways to decide whether a stock is a good investment or not, some work some don’t most work sometimes and sometimes they don’t. When it comes to predicting the movements of stocks, there are two major approaches: fundamental and technical analysis. Fundamental analysis focuses on the numbers the company provides through financial statements and tries to predict the future of the company based on those, it takes a look at things like debt, equity, sales, assets etc. it’s the main approach used by Warren Buffet and was popularized by Benjamin Graham author of the famous book “The Intelligent Investor”. Technical analysis instead of looking at financial statements looks at the price charts and tries to predict the future behavior of the stock by looking at common patterns that repeat themselves on the financial markets. On this post we’ll be focusing on fundamental analysis (On the most basic aspects and tools of it). While these tools are fairly simple, they provide very powerful metrics specially when used properly and can be an easy way for beginners to find good stocks, most of these are used on a daily basis by value investors. First, we’ll look into 6 ratios, the logic behind them and how to use them and finally we’ll take a look into a more advanced model that investors use but does require a lot of work and making some assumption. So, without further ado let’s take a look at these tools

Price to Earnings Ratio (P/E Ratio):

Formula:

The P/E ratio is used for measuring how overpriced/underpriced an asset is relative to something else. It can be used in a variety of ways, the most common is to compare a specific stock to other stocks on the same industry, the ratio comes from dividing the Share price by the Earning per Share(EPS) the idea behind the ratio is that if the number is too high (relative to the industry) the stock might be overvalued so if the stock has for example a P/E Ratio of 50, this means that for every 50 bucks you put into the company you get one dollar in return so the lower the number the better. As of February 2019, when this post is being written Apple sits at a P/E ratio of 13.74 which is actually pretty good given how long we’ve been at a bull market. Keep in mind that this is not a magic number where the lower the number the better, stock that are expected to grow a lot have higher PE ratios because investors are expecting those earnings to grow a lot, for example Netflix has a PE ratio of 126.81, this doesn’t mean Netflix is a bad investment. So, you should use many ratios when deciding on a stock.

Return On Equity

Formula:

Return on Equity (ROE) is a measure of performance, it basically looks at how efficiently is shareholder’s money being used, when a company buys the assets it needs, they do it through two ways debt and equity, equity is what stockholders own of the company, Assets minus Liabilities (Debt). The ROE looks at how efficiently is that money is being used by dividing the Net Income by the Shareholder Equity, the higher the number the better, if the number is high it means the manager are actually turning the money into sales and income if the number is low It mean’s that even if they are making a lot of income it’s relatively low to how much capital the company has. Afterall It’s not the same to make 10 million dollars (which sounds like a lot) when you’re a billion-dollar company as when you are million dollars start up that started last year.

Price to Book Ratio

Formula

On this ratio we look at something called the book value. What is the book value? The book value is an accounting measure and it basically means how much are all the tangible assets minus liabilities worth based on the balance sheet. The book value is what would be paid to shareholder’s if the company was not going to continue and everything was sold, what’s left after paying debt that’s the Book Value of the company. The Price to Book ratio is therefore a measure used to see how overpriced/underpriced a stock is but it only considers tangible assets like buildings, factories, cash etc. so it could be useful for checking whether a Transport company is overpriced but would be less useful for companies where most of the income comes from Intellectual Property like Patents or others types of ideas like in most Tech Companies where the buildings, vehicles and similar assets are not very relevant to calculating the real value of the company. That being said the lower the number the better and the less likely it’s that the company is overpriced.

Price/Earnings to Growth (PEG)

Formula:

As we mentioned in the PE ratio previously, a problem with the ratio is that it doesn’t consider how much the earnings are expected to grow and therefore a stable company with a 3% annual growth over the last 10 year is looked the same way as booming companies like Netflix and Amazon. Well, the PE to Growth aims to fix this issue by dividing the PE by the expected Earnings Growth, the idea here is that if a stock has a high growth, chances are that the PE will be really high so we divide it by that expected growth and we make the ratio smaller, that way we account for the expected growth. The expected Earnings Growth can be calculated in many ways, some just plug there the growth from the last year, others take the average of the annual growth of the last 5 years and so on and so forth. As with the PE ratio the lower the PEG ratio the better because it means that it’s undervalued relative to the competition.

Price to Sales

Formula:

A pretty self-explanatory measure, you divide the price per share by the revenue per share, alternatively you divide the total market capitalization by the revenue to get the same result. The lower the number the better, it means that most of price comes from real sales, overhyped companies tend to have a really high Price to Sales ratio.

Debt to Equity

Formula:

A bit of a different measure compared to the others, this is a risk measure. We’re looking at how big is the debt relative to the equity, the more a debt a company has relative to its equity the more likely it’s to go bankrupt if something bad happens be it a recession, a failed product, a marketing disaster or anything else. So, a high DE ratio is associated with high risk but it is not necessarily bad it might just mean that the company is having an aggressive growth strategy and is using leverage to speed up that growth, a low ratio isn’t necessarily good neither it just means the company won’t go bankrupt soon, but a low level of debt might mean that the company is not being aggressive enough and won’t grow much thanks to this. The optimal varies from industry but a DE ratio higher than 2.0 is usually a red flag but keep in mind that if in said industry the average is 3.0 or 4.0 then the 2.0 can even be too low so you need to compare it with the pertinent stocks.

Finally, I introduce to you a financial model, for educational purposes mostly because applying it will be very time consuming if you’re not an investment firm with lots of financial analysts.

Discounted Cash Flow Model (DCF)

The DCF is a valuation method and of the simplest financial models given that you already have the expected cash flows. But first we need to introduce the concept of present value and the formula:

This look complicated but it’s actually a fairly simple and intuitive concept, it comes from the idea that a dollar tomorrow is not worth the same as a dollar today. We know that we prefer a dollar today than tomorrow and there a dollar today is worth more than dollar tomorrow but exactly how much? Well in this model that depends on how certain is that dollar tomorrow in this example it’s 100% certain and therefore we use the risk-free rate, that is the interest rate paid by government bonds let’s say that the risk-free rate is 3%. Then if we invested \$100 today, we would get \$103 in one year and therefore \$100 today would be equal to \$103 in one year. Put in another way the \$103 can be brought to present value by discounting it at that 3% interest rate through the formula. In this case the cash flow we’re bringing to present value would be 103, the interest rate would be 3% and N which stands for number of periods would be 1 (1 year). So the formula would look like this:

Which if you solve it would be \$100. \$103 divided by 1.03 (because 1.03 to power of 1 is the same number). That´s the main concept behind the Discounted Cash Flow model, what we would do is forecast the cashflows and discount them. So, let’s solve an example so it makes more sense.

Let’s say we have the future cash flows of Netflix for the next 4 years and we believe the future earnings will be \$100, \$120, \$140 and \$160 respectively. And we know that companies similar in terms of risk to Netflix grow a 18% on average, therefore the rate we will use to discounting those earnings will be 18%. Then the sum of the present values of those cash flows will be the fair value of the company. The math would look something like this:

Notice that the exponents change, this is because the payment from second year for example needs to be discounted for the 2 years and so on. This would result in \$338.66, notice that the Present Values differs a lot from the sum of the cash flows which would add up to \$520, which is why discounting cash flows is really important in finance.

So I hope these tools can help you when you decide to pick your next stock, my last advice would be to look at different metrics and not base your decision on only one of these, because that would be the wrong way to use these tools and the fastest way to lose money on the markets.