The concept of value investing was first established by Benjamin Graham who was considered as the “father of value investing”. The idea of value investing is centered on fundamental principles that focus on identifying stocks that are worth more than their prices in the market.
Value investors can profit from the stock market by buying stocks when it falls below its intrinsic value. For those who are interested in adopting the value investing method, it is best to first understand financial statements to appreciate the key ratios that can determine if a stock is worth buying.
Read Also: Understanding Accounting Terms In 10 Minutes Part 2: Financial Statements [With Infographic]
#1 Strong Return On Equity (ROE)
Return on equity measures a corporation’s profitability by showing how much profit a company generates with the money shareholders have invested.
ROE is expressed as a percentage and calculated as:
ROE = Net Income / Shareholders’ Equity
Value investors use ROE as a profitability measure to gauge how well a company has performed over time. A high and consistent ROE indicates that the company has a sustainable competitive advantage. Companies that are able to consistently generate a 5 year average of 15% are good investment candidates. Even Warren Buffett considers ROE as an important profitability metric to determine whether a company is investing excess cash wisely.
However, ROE does not show if a company has excessive debt. Companies which have high debt-to-equity ratios tend to have higher ROEs. This might make the companies look profitable in the long run with respect to its ROE, but it also elevates risks as the debt to equity ratio has increased as well.
Where to find ROE:
Income Statement: Net Income
Balance Sheet: Shareholders’ Equity
#2 Low Debt-To-Equity Ratio (D/E ratio)
The D/E ratio has to be considered together with ROE. ROE measures a company’s financial leverage by dividing its total liabilities by stockholders’ equity.
D/E ratio = total liabilities / shareholders’ equity
The D/E ratio indicates what proportion of debt and equity the company is using to finance its assets. While debt is not necessarily a bad thing, excessive leverage exposes a company to huge risks, particularly during recessions. A good rule of thumb would be a D/E ratio of less than 30%.
Where to find D/E ratio: Balance sheet
#3 Low Price-to Earnings Ratio (P/E ratio)
This is one of the most commonly used ratios in value investing. Investors use this ratio to determine how much they are paying for a company’s earning power.
P/E ratio = price per share / earnings per share
A stock’s P/E ratio fluctuates consistently from changes in its stock price. Simply looking at stock prices would not provide sufficient insight to whether a stock is worth purchasing. It is riskier to invest in a stock that has a high P/E than one with a lower P/E since one would expect to get higher earnings growth for that extra money paid for the stock.
Mature companies (aka blue chip stocks) with low P/E often pay dividends while new, emerging companies with high P/E usually do not. A good guide would be a P/E of less than 15.
Where to find P/E ratio:
Market price: Use your preferred stock screener (we recommend SGX’s Stockfacts)
Income statement: Earnings per share (derived by dividing net income by number of shares outstanding)
#4 Low price-to-sales ratio (P/S ratio)
P/S ratio compares the stock price to sales revenue. It is derived by:
P/S ratio = Price / Sales Revenue
Although the P/E ratio is commonly used, companies can manipulate earnings in various ways. While managers can use accounting rules to get desired earnings, sales revenue cannot be adjusted significantly. The P/S ratio is more reliable than the P/E ratio as a tool to measure value for companies of all sizes. Generally, it is better to pick stocks that have a P/S ratio of less than 1.5
Where to find P/S ratio:
Market price: Use your preferred stock screener (we recommend SGX’s Stockfacts)
Income Statement: Sales Revenue
#5 Low Price-to-book ratio (P/B ratio)
This is also a very commonly used metric in value investing. P/B ratio compares a stock’s price to how much the stock is worth right now if somebody liquidated the company.
P/B ratio = Price / (total assets – intangible assets and liabilities)
If the ratio is less than 1, it means that you are paying less for the stock at its liquidated value. A lower P/B ratio could either mean that the stock is undervalued or the fundamental economics of the business have deteriorated and the market is now pricing the new valuation to reflect the firm’s weaker fundamentals.
Benjamin Graham recommends investors to buy stocks with a margin of safety, with no more than 2/3 of its book value (P/B < 0.66). This means that you should not be paying more than $66 for a company that has a book value of $100. Graham requires the low P/B to accompany a low P/E as well. By purchasing stocks that are cheap compared to its actual worth, investors can ignore market fluctuations.
Where to find P/B ratio:
Market price: Use your preferred stock screener (we recommend SGX’s Stockfacts)
Balance Sheet: Book value
Read Also: Step-By-Step Guide To Investing Better Using StockFacts
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